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The EVA Revolution
This book celebrates a revolution in management known as EVA. With all the attention it has gotten in the press, most executives have heard something about EVA by now. FORTUNE magazine has called it "today's hottest financial idea and getting hotter," and management guru Peter Drucker, writing in the Harvard Business Review, has described EVA as a vital measure of total factor productivity, one that reflects all the dimensions by which management can increase value. Still, we suspect that most executives, even those inside the finance department, still have only a vague notion of what EVA is and what it can do for their company. We hope to correct that by showing, with an absolute minimum of equations and financial jargon, that EVA truly is, to quote FORTUNE again, "the real key to creating wealth."
At its most basic, EVA, an acronym for economic value added, is a measure of corporate performance that differs from most others by including a charge against profit for the cost of all the capital a company employs. But EVA is much more than just a measure of performance. It is the framework for a complete financial management and incentive compensation system that can guide every decision a company makes, from the boardroom to the shop floor; that can transform a corporate culture; that can improve the working lives of everyone in an organization by making them more successful; and that can help them produce greater wealth for shareholders, customers, and themselves.
The capital charge in EVA is what economists call an opportunity cost. It is thereturn that investors could expect to get by putting their money in a portfolio of other stocks and bonds of comparable risk, and that they forego by owning the securities of the company in question. The capital charge embodies the fundamental precept, dating all the way back to Adam Smith, that a business has to produce a minimum, competitive return on all the capital invested in it. This cost of capital, or required rate of return, applies to equity as well as debt. Just as lenders demand their interest payments, shareholders insist on getting at least a minimum acceptable rate of return on the money they have at risk. Viewed another way, EVA is profit the way shareholders measure it. If shareholders expect a minimum return of, say, 12% on their investment, they don't begin to "make money" until profits rise above that.
As Peter Drucker put it in his 1995 Harvard Business Review article: "EVA is based on something we have known for a long time: What we call profits, the money left to service equity, is usually not profit at all. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources.... Until then it does not create wealth; it destroys it." Many corporate managers have forgotten this basic principle because they have been conditioned to focus on conventional accounting profits, which include a de-duction for interest payments on debt but have no provision at all for the cost of equity capital. Worse still, most line managers focus on operating profits, which don't even have a charge for debt. True profits don't begin until the cost of capital, like all other costs, has been covered.
EVA is a measure of those true profits. Arithmetically, it is after-tax operating profits minus the appropriate capital charge for both debt and equity. What remains is the dollar amount by which profits in any given period exceed or fall short of the cost of all capital used to produce those profits. This is a number that economists refer to as residual income, which means exactly what it implies: It is the residue left over after all costs have been covered. Economists also refer to this as economic profit or economic rent. We call it EVA, for economic value added. It's that simple, though the actual calculation of EVA is somewhat more complicated. It first requires a number of decisions (which will be discussed in detail later on) about how to properly measure operating profits, how to measure capital, and how to determine the cost of capital. Here's the formula:
where NOPAT is net operating profits after taxes, C% is the percentage cost of capital, and TC is total capital.
This simple formula is the foundation for a revolution in management. "Revolution" is a horridly overused word, of course, routinely summoned into service to pump up management fads that barely qualify as mild disturbances. But we are confident that you will come to agree that EVA is a bona fide revolution, one that can help any corporation, public or private, in any industry, produce superior results for shareholders, employees, and customers. The EVA revolution already is well under way. More than 300 companies on every continent (except Antarctica, of course), with revenues approaching a trillion dollars a year, have implemented Stern Stewart's EVA framework for financial management and incentive compensation. EVA, in turn, has helped the managers of these companies create hundreds of billions of dollars in shareholder wealth that wouldn't otherwise exist.
The Coca-Cola Company, for example, had long been No. 1 in soft drinks but it was decidedly mediocre in the wealth creation department in 1983 when the late Roberto Goizueta became one of the first chief executive officers to adopt EVA. Yet by 1994 Coke had become the No. 1 wealth creator in the world, and by the end of 1996 its sugar water had enriched shareholders by $125 billion. As CEO, Goizueta plainly deserves the credit for Coke's stupendous performance, but EVA played an important role. "We are very pleased to have been one of the first on board the EVA wagon," Goizueta said in 1995. "EVA has given our people a very useful tool for running their individual business units and a sound principle to guide their daily behavior."
The stocks of more recent converts--Eli Lilly, Monsanto, Briggs & Stratton, and Herman Miller, to name a few--have been exceptionally strong performers since those corporations made the switch to EVA, far outpacing the overall market and other companies in their industries. SPX Corporation, a faltering auto parts company in Muskegon, Michigan, implemented EVA in 1996, and its stock price shot from the mid teens to $69 a share in just two years; the company created nearly $350 million of shareholder wealth in its first year on EVA and another $400 million in the second year. SPX workers, so recently demoralized, have become proud, charged-up members of a winning team. EVA is helping reshape South African business as that country moves out from under the stifling blanket of trade embargoes and relearns how to compete in the global market. New Zealand is using EVA to invigorate its state-owned enterprises. Even the United States Postal Service is using EVA to improve efficiency and service and to motivate the largest civilian labor force in the world.
EVA also has gained broad acceptance in the academic community and the business press, and it is changing the way Wall Street picks stocks. Some of the Street's most prominent firms, including Goldman Sachs and Credit Suisse First Boston, have formally adopted EVA as a principal tool for valuing companies, and many others in the United States, Europe, Asia, and Latin America are following their lead. Major institutional investors are turning to EVA as well. Oppenheimer Capital, a pension and mutual fund manager with an exceptionally good track record, has a special affinity for EVA companies. And the California Public Employee Retirement System (CalPERS), the leader in the shareholder activism movement, is now using poor EVA performance to identify the list of "focus" companies it selects each year as those most in need of governance reform. Says Bob Boldt, a senior investment officer at CalPERS: "It's simple enough to apply consistently to all companies but complex enough to be useful in showing real economic returns."
EVA resonates with so many constituencies because it entails much more than a fleeting emphasis on a single aspect of corporate performance. Rather, EVA is a return to basics, a rediscovery of the most fundamental elements of business management that brings a lasting change in a company's priorities, systems, and culture. EVA has been proven to work virtually everywhere because it is the right approach for all companies in all times and in all environments.
Like so many revolutionary innovations, this simple tool can be put to extraordinary use. At heart, it is the practical application of both modern financial theory and classical economics to the problems of running a business, an application that turns out to provide the most effective framework for corporate decision making in a period of remarkable economic change. In some ways, it's no surprise that EVA, which attunes managers to the discipline of markets by focusing them on capital costs, has come to the fore in an era when the world has been won over to free enterprise, and markets rule. What EVA is not is another form of rightsizing or downsizing or the financial version of reengineering. Nor is it a fad. EVA is a fundamental way of measuring and managing corporate performance that has roots as old as capitalism itself. It tells managers to do those things that they intuitively know are the right things to do, but that so often are obscured by conventional accounting-based measures of performance.
When companies employ EVA to the fullest, which is what they must do to change behavior, it becomes far more than just another way of adding up costs and computing profits. It is:
- The corporate performance measure that is tied most directly, both theoretically and empirically, to the creation of shareholder wealth; as you will see, managing for higher EVA is, by definition, managing for a higher stock price.
- The only performance measure that always gives the "right" answer, in the sense that more EVA always is unambiguously better for shareholders, which makes it the only genuine continuous-improvement metric; in contrast, actions that increase profit margins, earnings per share, and even rates of return sometimes destroy shareholder wealth.
- The framework underlying a comprehensive new system of corporate financial management that guides every decision, from annual operating budgets to capital budgeting, strategic planning, and acquisitions and divestitures.
- A simple but effective method for teaching business literacy to even the least sophisticated workers.
- The key variable in a unique incentive compensation system that, for the first time, truly aligns the interests of managers with those of shareholders and causes managers to think like and act like owners.
- A framework that companies can use to communicate their goals and achievements to investors, and that investors can use to identify companies with superior performance prospects--what Steve Einhorn, director of global equity research at Goldman Sachs, calls "a power tool in the analyst's tool kit."
- Most important, an internal system of corporate governance that motivates all managers and employees to work coopera-tively and enthusiastically to achieve the very best performance possible.
The financial management system--the set of financial policies and procedures, and measures and methods, that guide and control a company's operations and strategy--concerns such things as setting and communicating financial goals, both internally and externally; evaluating both short-term profit plans and long-term strategic plans; allocating resources, from deciding whether to buy a new piece of equipment to acquiring and divesting entire companies; evaluating operating performance from a financial perspective; and tracing the sources of that performance back to the strategic and operating levers available to managers.
Those are things that all companies must do, but our experience is that most companies do them badly. Indeed, the typical financial management system today isn't a system at all. Rather, it's a hodge-podge of rules, guidelines, and procedures that employs an array of frequently contradictory measures and objectives, that fosters confusion and conflict within an organization, that focuses on performance variables that bear little relation to the value of a business, and that often leads smart managers to do dumb things. Companies may evaluate individual products or lines of business on the basis of operating profits. Business units may be evaluated in terms of return on assets or a budgeted profit figure. Finance departments analyze capital investments in terms of discounted cash flow, but evaluate acquisitions by the effect on earnings growth. EVA, in contrast, provides a single, consistent focus, and allows all decisions to be modeled, monitored, communicated, and evaluated in exactly the same terms--the incremental wealth that a particular course of action will create or destroy.
The EVA framework provides a new lens through which managers view a corporation, a lens that gives a clearer perception of the underlying economics of a business and enables any manager to make better decisions. The capital charge, for example, causes managers throughout a company to consider the effects that their decisions have on the balance sheet as well as the income statement, and gives them a clear, objective basis for weighing trade-offs between the two. Suddenly, production managers begin optimizing the trade-off between long production runs that boost operating profits by reducing unit costs and the higher inventories (and capital costs) that long runs require. Salespeople learn that the generous payment terms they grant in order to land a big order can actually suck all the economic profit out of a sale. As you will see from examples later on, it is hard to overstate the impact that capital awareness can have on the true bottom line and on the ability of an organization to learn and improve in ways that build real competitive advantage.
The EVA system enables managers to make better decisions by providing them with superior information and insights. But information alone won't cause managers to choose the actions that maximize economic profits and shareholder wealth, especially when those actions are difficult or unpleasant. The real magic in EVA comes from changing behavior throughout an organization, and that depends crucially on using it as the basis for incentive compensation. Indeed, if all a company intends to do is measure EVA and use it as one more benchmark of performance, it probably isn't worth the bother. Merely measuring and monitoring EVA is akin to a New Yorker checking the temperature in Honolulu in February: It may be interesting information, but it doesn't affect how you dress.
Many operating managers are gifted with great ingenuity, and all of them have an intense desire to succeed. A central question faced by all top managers and boards of directors is how to harness that ingenuity and desire and direct it in ways that maximize the success of both the individual and the enterprise. The answer lies in human nature: People do what you reward them for doing, not what you exhort them to do. Base incentives on higher operating margins, and you will get higher operating margins, even if it means that sales fall off a cliff. Pay for sales increases, and you'll get more sales; pay for market share, and you'll get market share. The secondary goals and initiatives sent down from the executive suite may get some atten-tion, but a manager or worker's real energy will be focused on the variable that drives his or her bonus or is most likely to lead to a promotion. Thus, if you pay people for generating more EVA, you will get more EVA and, with it, a higher share price and greater shareholder wealth. You also will get a more successful organization that provides greater nonmonetary satisfaction as well.
However--and this is a big however--simply plugging EVA into a conventional, run-of-the-boardroom incentive scheme won't get you anywhere near the performance gains that most organizations are capable of achieving. In fact, the modal incentive compensation system in use today actually is a disincentive system. If you properly analyze the way incentives affect behavior, which we do in Chapter 7, you find that the typical bonus scheme places far too much emphasis on the short term, provides little or no motivation for superior performance, causes managers to be excessively conservative, and encourages them to sit on their hands in boom times and bad times. In short, most incentive schemes drive companies to underperform their potential. They also tend to pay too much for mediocrity and way, way too little for outstanding performance.
We prefer a type of incentive plan that differs radically from the norm. The most important difference is that EVA bonus plans work: They give managers the same visceral identification that an owner has with the success or failure of an enterprise. EVA bonus plans make managers think like and act like owners by paying them like owners. We do that by calculating cash bonuses as a fixed percentage of increases in EVA--in other words, by giving managers a piece of the EVA action. EVA bonus plans also violate two cardinal rules laid down by the big compensation consulting firms. Rule breaker No. 1 is that these bonuses don't have any caps. The more EVA increases, the bigger the bonus--without limits. We are able to do away with upper limits because we pay only for sustainable increases in EVA. A portion of any exceptional bonus award goes into a "bonus bank" for payment in future years, and is forfeited if EVA subsequently falls. Rule breaker No. 2 is that the targets for EVA improvement under the bonus plan are automatically reset by formula instead of negotiating a budgeted level of improvement each year.
The rule breakers are key to the efficacy of EVA incentive plans, which in turn are the heart of the EVA governance system. Doing away with the conventional bonus cap gives a manager a pecuniary reason to continue striving for better and better performance even in boom years. Under conventional incentive plans, in contrast, managers have every reason to go into the leisure mode once their bonuses have "capped out," and to engage in wealth-destroying behavior such as pushing additional sales into the next bonus year. The bonus bank, meanwhile, guards against the temptation to game the system by sacrificing the future for short-term gain. It also gives managers a reason to work long hours to minimize the carnage in a business downturn. Having money at risk in the bonus bank is what turns managers into genuine owners and causes them to lengthen their horizons, constantly seeking out new sources of sustainable, long-term improvement. Similarly, the automatic reset feature spurs performance by decoupling bonuses from annual budgets. Managers with conventional incentive schemes typically try to negotiate modest, easily achievable profit plans in order to be sure of collecting their bonuses. Managers under an EVA bonus plan are encouraged to propose aggressive budgets because they won't be penalized for falling short, and they will get paid extra for everything they do achieve. They swing for the fences instead of settling for singles.
Stock market professionals have begun to pick up on the value that EVA incentives help create. Tony Kreisel of Putnam Investments Management and Andy Pilara of the Robertson Stephens money management firm have a decided preference for companies with EVA bonus plans. So, too, does Eugene Vesell, a senior portfolio manager at Oppenheimer Capital. "We look for managements whose philosophy focuses on the intelligent use of capital as measured by EVA," says Vesell. "We want managements who are incentivized on an EVA basis to produce long-term returns well above their cost of capital." Some securities analysts look on the adoption of an EVA bonus plan as a "buy" indication. When Andrew Cash of PaineWebber raised his recommendation on Olin Corporation from neutral to buy in August 1995, his key message was, "EVA and new compensation system to the rescue." He wrote: "Starting in 1996 management will have 80% or more of their bonus compensation tied to EVA goals. No economic profit through a cycle, no bonus!" Cash's recommendation and a similar one by Leslie Ravitz of Morgan Stanley helped lift Olin stock from $52 to $76 a share in just four months.
Some essential elements in the governance aspect of EVA should be apparent by now. The EVA financial management system shows managers which decisions will increase economic profits and generate the most wealth for shareholders. The bonus system acts as the owner's control mechanism by ensuring that it is in the manager's self-interest to pursue the shareholder's interest. At the same time, the bonus system puts the manager's wealth at risk and penalizes him or her for failing to produce a minimum required rate of return. In essence, this is pay for results, not pay for performance. As Bennett Stewart, the senior partner of Stern Stewart, is fond of saying, "EVA makes managers rich, but only if they make shareholders filthy rich."
At heart, EVA isn't about finance or economics, it's about people. The most valuable resource in any company is the creativity and the will to succeed that all people possess, and usually to a much greater degree than they get credit for. EVA is a means to unlock the potential for achievement that exists throughout every organization. No magic formula handed down by top management or the finance department can accomplish that. But a management system that provides employees with better information and insights, that makes them accountable for performance, and that properly rewards them for success can produce remarkable results. Adopting EVA doesn't magically transform managers into latter-day Hyperboreans who automatically enjoy rising profits through every economic climate. Creating wealth still requires great ingenuity and tireless effort, but those who are equipped with better information and better motivation are far more likely to succeed.
As you undoubtedly have gleaned by now, the EVA system is founded on the proposition that the primary responsibility of management is to maximize shareholder wealth by getting the stock price as high as possible. This view is somewhat controversial, to say the least. Even in the United States, the apogee of free-market economics, many people argue that the single-minded pursuit of shareholder wealth, however it may be measured, is too narrow and coldhearted. Even some corporate chieftains--and many others who ought to know better--argue that such an approach is socially and economically irresponsible because it ignores important and deserving stake-holders, including employees, customers, the communities where companies operate, the environment, and even the long-term interests of shareholders themselves. In fact, maximizing shareholder wealth is the best way--indeed, the only way--to effectively serve the long-term interests of all stakeholders. It is the only policy that is genuinely fair to workers. (It also is the only way chief executives can be confident of keeping their jobs in today's environment.)
Few would argue that the proverbial corner grocer should do anything other than run the store to make as much money as possible. But the issue becomes murkier when we move from the owner-operator of a small enterprise (or even a large one) to the professional managers of major corporations with millions of far-flung shareholders. In the stakeholder view of things, shareholders have become so disperse, and their ownership of shares often so fleeting, that they have forfeited their primacy. Simply holding shares doesn't qualify as ownership in the full sense of the word, they say. This is particularly true when the shareholder is further separated from the company by an institutional portfolio manager whose only concern may be to beat the market this quarter in order to buy a Porsche Turbo or, if the manager picks stocks really well, a McLaren F1. Stakeholder advocates maintain that the true responsibility of boards of directors is to balance the claims of competing constituencies, forsaking shareholders whenever their interests unduly infringe on those of employees, the community, or some other deserving group.
Many CEOs are drawn instinctively to the stakeholder philosophy. It is the one most consistent with the parochial conception of the corporation as a quasi-organic entity with a life of its own. This attitude characterized U. S. management in the decades following World War II, and still dominates in much of Europe and Asia today. As Gordon Donaldson of the Harvard Business School observes in Corporate Restructuring: Managing the Change Process from Within: "In the late Sixties and most of the Seventies, the typical mind-set of top management can be described as follows: an introverted, corporate-centered view of the business mission focused on growth, diversification, and opportunity for the 'corporate family. ' In the corporate rhetoric of that period, reference to the stockholder interest was strangely absent, and there was often even a renunciation of 'purely economic' goals."
And what if, as the Donaldson quote implies, the pursuit of growth and diversification for their own sake happened to be hazardous to shareholder wealth? No problem. In those days most corporate boards were Greek choruses that routinely ratified whatever a CEO wanted to do. They replaced CEOs only with the most extreme provocation, such as RCA chief Edgar Griffiths' bizarre failure to file personal income-tax returns for several years. And if stockholders were disappointed in a company's performance, they politely sold their shares and moved on to another investment in what used to be known as "the Wall Street walk." Institutional investors rarely raised objections to corporate actions, and were ignored when they did. Managers also were largely immune to the threat of a takeover. The unfriendly tender offer was the corporate equivalent of mustard gas, and anyone with the audacity to use it was promptly ostracized from the community of respectable executives.
But just as nature abhors a vacuum, markets won't tolerate wasted resources and unexploited opportunities indefinitely. By the late 1970s a profusion of poorly performing companies brought forth a new class of corporate raiders, and Wall Street found ways to finance them. Suddenly, it seemed that everyone was using mustard gas. Even AT& T and American Express, two corporations that once had the whitest shoes on the FORTUNE 500, made hostile bids for other companies (American Express muffed its play for McGraw-Hill; AT& T, to its regret, succeeded in overpaying for NCR Corporation). Soon after corporate raiders put the fear of tender offers in the hearts of underperforming managers, a cadre of institutional investors began waving the flag of ownership and banging on boardroom doors. The institutions--the owners--were about as welcome as an Environmental Protection Agency inspector. As late as 1991, 10 of the 12 companies on CalPERS's list of egregious underperformers refused even to meet with the fund's representatives.
Unsurprisingly, the managerial establishment railed against what the press called the takeover wars and the academics dryly termed the "market for corporate control." A disdain for shareholders comes through loudly in a 1990 report on corporate governance by the Business Roundtable (the club made up of CEOs of the 200 largest corporations in the United States): "Shareholder voting on such things as acquisitions and divestitures can put immediate shareholder financial return ahead of sound longer-term growth which may have the potential of being even more rewarding to the corporation, its shareholders and its other stakeholders" (emphasis added).
The Roundtable could have taken its text from Time Inc. 's acquisition of Warner Communications the year before. The Time-Warner deal represented the most egregious instance of stakeholder pleading ever, at least in terms of the shareholder wealth sacrificed. While the Time-Warner deal was pending, Martin Davis of Paramount Communications intervened with an offer of $180 a share for Time, which had been trading around $135. Davis subsequently raised his offer to $200, but Time's board asked the Delaware court to prevent Time shareholders from taking it. Time argued that its heritage of journalistic integrity is a "sacred trust," and that a takeover by the Philistines at Paramount might do unconscionable harm to the readers of Time, People, and Southern Living.
The Delaware Chancery Court blocked Davis's tender offer, depriving Time shareholders of a $6.5-billion premium over what their shares were worth before Davis entered the fray. It then took Time Warner Inc. stock eight years to rise to the price Davis had offered. The rate of return (including dividends) on Time stock over the period was less than one-third that of the Standard & Poor's 500 index--5.1% versus 16.6%. So, after preventing shareholders from getting a premium, the Time board presided over a lousy investment as well. If one measures the total shareholder loss as what Time's owners would have had by July 1997 if they had been able to take Davis's offer and had reinvested the entire proceeds in an S& P index fund, the court decision cost them $56 billion. People's readers owe a much greater debt to the shareholders than they realize.
All companies fail to maximize shareholder returns to some degree. Try to name a single one that does everything super-efficiently all the time and has no executive perks that aren't absolutely essential to the enterprise. But the pressure to perform has become much more intense in recent years. Today's CEOs know that if they fail in a big way, whether from malfeasance, misfeasance, or nonfeasance, they're out. Even if no raiders come calling, those pesky institutions will see to it, and the CEO's newly fickle friends on the board will go along with them. Just ask John Akers of IBM, Robert Stempel of General Motors, Jimmy Robinson of American Express, Paul Lego of Westinghouse, or any of a host of other displaced chief executives. Hence all the corporate trumpeting of shareholder value initiatives. As any reader of annual reports knows, the mantra of "managing for shareholder value" has become a sine qua non of corporate political correctness. Most companies still are in the dark about exactly how they're supposed to go about managing for shareholder value, but virtually all of them say they are doing it.
After two decades in which corporate raiders have, for the most part, put wasted assets to better use, even the Business Roundtable has finally got the objective right. In a remarkable statement on corporate governance that was crafted under the leadership of Chase Manhattan CEO Walter Shipley in 1997, the Roundtable took the position that "the principle objective of a business enterprise is to generate economic returns to its owners." It went on to say, "The notion that the board must somehow balance the interests of stockholders against the interests of other stakeholders fundamentally misconstrues the role of directors. It is, moreover, an unworkable notion because it would leave the board with no criterion for resolving conflicts between interests of stockholders and of other stakeholders or among different groups of stakeholders."
Why should managers and directors put shareholders ahead of all others? The most obvious reason is that they own the place, but there are more compelling, though less obvious, reasons to maximize shareholder wealth that have little to do with this "finance view" of the corporation. These reasons are founded instead on pure pragmatism. The simple fact is that in a market economy, everyone fares best in the long run when management puts shareholders first.
First and foremost, maximizing shareholder wealth is the action that takes Adam Smith's invisible hand out of its pocket and puts it to work guiding resources to their most productive and highly valued uses. Business, after all, is the greatest engine of wealth in society, and the process of creating shareholder wealth is the same process that creates greater wealth for everyone in an economy. Indeed, creating wealth is the only real source of social security. If companies do not pursue the maximum shareholder wealth possible, resources are squandered and society is poorer. Paradoxically, it is only because we care about maximizing the wealth available for everyone that we should care about maximizing the wealth of shareholders at all. Improving the commonweal is the real reason why maximizing shareholder wealth is so important, and it is the reason why the overriding purpose of corporate governance ought to be to ensure that this rule is followed.
What's more, managers simply cannot create enduring shareholder wealth by abusing other stakeholders. That is because a corporation is nothing more, or less, than what economist Ronald Coase called a nexus of contracts. Written or implied, explicit or merely understood, these contracts are covenants between the company and its stakeholders. Labor, management, and suppliers come together voluntarily and use capital put up by investors to create a product that they hope customers will buy. If management deals shabbily with any constituency--if it violates the contract--the victim will simply stop volunteering. If a company tries to pay wages that are too low, it won't be able to hire the quality of workers it wants and needs. If it pays suppliers too slowly, they will raise prices or demand payment on delivery. If its products fall short of the quality it promises, customers will turn to the competition.
As the Roundtable put the matter in its 1997 statement: "To manage the corporation in the long-term interests of the stockholders, management and the board of directors must take into account the interests of the corporation's other stakeholders." That is due in no small part to the fact that shareholders are the ones who get paid last, only after a company has paid its employees, paid its suppliers, paid its lenders, and paid its taxes. Smart managers understand that the surest way to provide handsome returns to shareholders is to treat all stakeholders well. Not all managers are smart, of course, and some do try to take advantage of one constituency or another. But the long-term costs from a tarnished reputation almost always outweigh any short-run benefits.
It is more than coincidental that research by Curtis C. Verschoor, a professor of accounting at DePaul University, has found a highly significant relationship between financial performance and a corporate commitment to ethical behavior. Verschoor divided 296 large companies into three groups--those that make no commitment in their annual reports to a code of ethics or conduct, those that make some commitment, and those that make a strong commitment. He then compared the market value added, or MVA, of the companies. (MVA is a measure of shareholder wealth creation that is explained in Chapter 3.) Verschoor found that the companies that stressed a strong commitment to ethics had an average MVA of $16.8 billion, versus an average MVA of $11.1 billion for those with some commitment and $5.7 billion for those with no mention of ethics. As John Shiely, president of Briggs & Stratton, puts the matter: "Value-creating companies recognize the importance of ethical behavior."
Top managers and directors have another pragmatic reason to put shareholders first. This one stems from the fact that all corporations, regardless of what they produce or where they produce it, have to compete for a scarce resource called capital. Capital is the medium of exchange that all companies must have to acquire the inputs--labor, materials, technology, and know-how--to produce goods and services to sell to customers. A company's ability to acquire capital at attractive prices depends on how well it performs as a steward of the capital it already has. Those that create shareholder wealth by returning more than the cost of capital will find it easier to raise additional money to invent new products, improve the quality of existing ones, enter new markets, and create more jobs. A company that consistently earns less than the cost of capital, either through ineptitude or by sacrificing shareholder interests to please another stakeholder group, will find that its shares sell at a discount. Additional capital will become increasingly difficult and expensive to come by, the CEO's job will be in jeopardy, the company may become subject to hostile takeover bids, and it ultimately will end up closing plants and offices and firing workers. How quickly these penalties are meted out depends in part on the openness of capital markets and the market for corporate control, but they ultimately are inescapable.
Roberto Goizueta had an uncommon grasp of the overarching importance of creating shareholder wealth. In Coca-Cola's 1993 annual report, Goizueta stated that Coke possessed "a precise focus on why we exist: to create real value for our shareholders over the long term." Expanding on that thought three years later, Goizueta wrote in the 1996 annual report: "Governments are created to help meet civic needs. Philanthropies are created to meet social needs. And companies are created to meet economic needs." Companies that do their job well, he continued, "contribute to society in very meaningful ways." The wealth that Goizueta created certainly contributed meaningfully to Coke's hometown of Atlanta. Shortly after his death in 1997, the Wall Street Journal reported just a few of the beneficent things that came about because of the wealth Goizueta created for shareholders:
- Nick Smith, 44, Goizueta's dentist, has a very comfortable nest egg for retirement because he steadily invested in Coke stock ever since he bought his first block of 100 shares in 1984 for $6,237.50, an investment that by itself climbed to a mid-1997 value of $180,000 after four stock splits and reinvested dividends.
- Four local philanthropies that hold Coke stock--the Robert W. Woodruff, Joseph P. Whitehead, Lettie Pate Evans, and Lettie Pate Whitehead foundations--boosted charitable giving from $5 million in 1980 to about $220 million in 1997. Together they have a value of $7.6 billion, almost all from the value of their holdings of 119 million Coke shares.
- One beneficiary of their giving is Trees Atlanta, a group accustomed to planting only about 100 trees a year on an $80,000 annual budget. With the foundations chipping in $2 million, the group planted 15,000 oaks, maples, magnolias, and hollies from 1992 to 1996, sprucing up the city in time for the Olympic Games.
- Emory University has seen its own endowment rise in value from $250 million in 1981 to become one of the nation's largest at $3.8 billion. The university holds about 40 million Coke shares, making up 63% of the value of that endowment. Emory has built facilities, offered scholarships, endowed professorships, and expanded programs that might not have been funded without the gain in its endowment wealth.
- An example of the endowment at work is the Roberto C. Goizueta Business School at Emory. At the dedication ceremony in the summer of 1997, Goizueta's son, Roberto S., a theology student at Loyola, thanked Emory and the audience on behalf of his then ailing father: "Dad believed very strongly that business is the best way to contribute to society--because it is how opportunity is created."
The EVA approach to wealth creation also can be extremely rewarding to workers. Just ask the folks at Herman Miller, the Zeeland, Michigan, furniture maker that is renowned for its Eames lounge chair and other superb designs. Miller is equally famous for its egalitarian style of management. Nearly a half-century ago, the company became one of the first to adopt a Scanlon plan in which all employees share in the profits of the enterprise. Herman Miller prides itself on treating all employees as equals, and was an early leader in the development of participative management and work teams. Yet the management team at Herman Miller has always recognized that wealth creation is essential to success. As Hugh DePree, the son of founder J. J. DePree, wrote in the corporate history, Business as Unusual, the philosophy at Herman Miller always emphasized performance and productivity as keys to the well-being of the organization.
Even so, Herman Miller ran into trouble in the mid-1990s. Coming out of a huge slump in the office furniture business, the company's sales were growing faster than the industry's, but the results weren't showing up on the bottom line. "We had effectively lost our way," says chief financial officer (CFO) Brian Walker. "We were throwing all kinds of assets onto the balance sheet that were not productive or we didn't need. We really thought capital was free, and so the business was having a heart attack." That's when top management turned to EVA, which it saw as being particularly well suited to the company's environment of what it calls employee-owners (they all have stock).
The managers were right. In its first full year on the new financial management system, Herman Miller's EVA jumped from $10 million to more than $40 million. "EVA analysis has enabled us to identify waste in both our costs and our use of capital," says CEO Michael A. Volkema. "This has led to the reduction of nonproductive assets such as inventory and accounts receivable." Over the past two years, as sales have risen 38%, Herman Miller employees found ways to cut inventories 24% and reduce the total square footage of building space by more than 15%.
Herman Miller also has cut its receivables days outstanding from 45 in 1992 to just 30 in 1997. But Herman Miller didn't speed up payments because the controller's office ordered the divisions to hector customers. When they went on EVA and began focusing on capital costs like receivables, Miller employees in the divisions attacked the late payment problem on their own and discovered that the cause of overdue receivables was incomplete orders. When an order arrived missing a piece or two, the customer would withhold all payments until the last items arrived. So the Millerites got receivables down by speeding up production of those missing items and making sure shipments were complete as well as on time. The result: improvements in both EVA and customer satisfaction.
The changes have paid off for shareholders, pushing Herman Miller stock from a low of $27 a share in 1995 to a high of $36.25 in the early months of 1998--after a four-for-one stock split. EVA also has profited the Herman Miller workers. "EVA has been a great tool for the people of Herman Miller," says Volkema. "Our people understand it and put it to work every day. EVA builds on our historic strength of employee participation, allowing our employee-owners to better understand the impact of their actions, resulting in better decisions for our customers and our business. We've seen our business grow, but equally important, we've seen our people grow in their commitment and contribution to Herman Miller." Their net worths have grown as well. Volkema estimates that the wealth of Herman Miller employees rose more than $100 million in less than two years on EVA. In the third quarter of fiscal 1997 alone, rank-and-file employees got an EVA bonus payout equal to 31% of wages.
Just as maximizing shareholder wealth enriches everyone, the failure to do so diminishes living standards. Proof of this can been seen in a fascinating 1996 study of international productivity by the McKinsey Global Institute, part of McKinsey & Company. The researchers wanted to solve two riddles: Why is German labor productivity lower than United States productivity even though Germany uses 40% more capital per worker than the United States? And why is per capita output lower in Japan than in the United States when Japan has saved so much more and its people work many more hours per year? The German situation is a paradox because the amount of capital per worker is a key determinant of labor productivity. With 40% more capital per worker, Germany ought to have much higher output per capita despite the fact that its people work only 82% as many hours per year as Americans. The Japanese situation seems even more puzzling. Its people invest more money and more time and energy to get back less in return. The researchers concluded that the answers to the two riddles are the same. The reason that both countries have lower output per capita isn't because there is something wrong with German or Japanese workers. The problem is that capital productivity in both countries is less than two-thirds the level in the United States. In other words, the problem isn't labor productivity. Rather, it is the efficiency with which managers use the capital they have invested.
Why does this matter? Because higher capital productivity means that American workers are much better off than their German or Japanese counterparts. In comparison with German workers, whose earnings are very close to those in the United States, U. S. workers save less of their incomes and consume more, enjoying a much higher standard of living. Meanwhile, the greater capital productivity gives rise to higher rates of return on investments, so that the savings of American workers grow faster and they wind up with greater financial assets and a better lifestyle in retirement even though they save less. The comparison with Japanese workers is even more favorable. Americans work less, save much less, have a much better lifestyle, and wind up with greater financial assets. That's pretty good, and all because companies are using capital more productively.
But why the difference? The researchers concluded that it is because German and Japanese managers put other priorities ahead of shareholder wealth, and not because of any fundamental differences in the two societies. Concluded McKinsey: "Surprisingly, we found that managers in Japan and Germany could achieve performance close to U. S. levels if they ran their companies differently, which they appear free to do. Formal external constraints, such as labor laws and rules, do not fundamentally restrict improvement opportunities." Part of the problem in Germany is the overengineering and gold-plating of facilities, something that may be peculiar to the German psyche but seems to afflict production managers everywhere. A bigger problem in both countries is the practice of buying domestic goods rather than imports even when the imports are cheaper. The Germans and Japanese take their economic chauvinism much more seriously than Lee Iacocca, who filmed a "Buy American" TV spot wearing a Burberry raincoat. And the Germans and Japanese pay a heavy price for it. The McKinsey researchers estimate that global sourcing of equipment could save German and Japanese companies from 10% in the food industry to as much as 60% in telecommunications.
One of the biggest differences between the United States and other countries, McKinsey observes, is the greater discipline of the stock market: "More so in the U. S. than elsewhere, the capital market boosts productivity because it gives managers a clear primary objective--financial performance--that generally guides them to use their resources productively. Furthermore, the U. S. capital market complements the competitive pressures of the product market by cutting off funds to failing firms. Consequently, the high levels of productivity attained in most U. S. industries do not square with the 'conventional wisdom' that the U. S. capital market undermines economic performance by forcing firms to be too focused on short-term results." Lest you think McKinsey is giving too much credit to the stock market, consider this: The takeover movement began forcing managers to focus more squarely on stock returns in the late seventies and early eighties, and the eighties happen to be the first decade in the postwar era when U. S. competitiveness increased relative to other industrial nations.
While the United States leads the world in productivity and living standards, our experience indicates that most corporations still waste prodigious amounts of capital. Every company Stern Stewart has worked with to implement EVA has discovered deep pockets of capital inefficiency when managers began focusing on the balance sheet as well as the income statement. That's actually very good news, because it means there still is room for enormous immediate gains in wealth creation in the United States. The potential elsewhere, of course, is much greater.
The coming chapters will explain why every company should be using the EVA financial management and incentive compensation systems to measure performance, shape decisions, and motivate employees. We will explain how to measure wealth creation and how to directly compare the performances of companies in different industries, and why managing for higher EVA is the surest way to create wealth. Along the way, we also will describe how some pathbreaking companies already have used EVA to unlock the wealth-creating ingenuity that exists in all enterprises.