ssrn id156288 eva,cva dcf

G OTHENBURG S TUDIES IN FINANCIAL ECONOMICS971214

VALUE BASED MANAGEMENT: Economic Value Added or Cash Value Added?

by Fredrik Weissenrieder Department of Economics Gothenburg University and Consultant within Value Based Management Anelda AB V. Hamngatan 20 S-411 17 G teborg Sweden

S TUDY NO 1997:3VALUE BASED MANAGEMENT: Economic Value Added or Cash Value Added? by Fredrik Weissenrieder

VALUE BASED MANAGEMENT:

by

Table of Content: 1 Introduction 3 CVA and the concept of Strategic Investments 4 EVA 4.1 EVA's corrections - Do they work in practice? 8 4.1.2 Irrelevant issues are discussed 5 EVA instead of Cash Flow? 5.1 EVA at H&M/Wal-Mart 5.1.1 EVA at store no 6 5.1.2 EVA at the parent 5.2 CVA at H&M/Wal-Mart 5.2.1 CVA at store no 6 5.2.2 CVA at the parent 5.3 EVA compared to CVA at H&M/Wal-Mart 17 20 6 Completing the "Circular Reference" 6.2 CVA vs. EVA using annuity depreciation 25 st adjustment nd adjustment 7 Market Value Added - MVA 8 Conclusion 38 3

Fredrik Weissenrieder, 1998

http://www.anelda.com

Corporate managers now face a period where a new economic framework that better reflects value and profitability must be implemented in their companies. Accounting systems, which has been used up until today, are insufficient and will not stand the challenge from the increasingly efficient capital markets and owners. The increased efficiency at the capital markets requires that capital allocation within companies become more efficient and it is therefore not possible for companies to in the future allocate capital as inefficient as they do today. A new economic framework, a Value Based Management framework that better reflects opportunities and pitfalls, is therefore necessary. In my opinion, there are four major frameworks within Value Based Management; Economic Value Added (EVA 1 ), Cash Value Added (CVA 2 ), Cash Flow Return on Investments (CFROI), and Shareholder Value Analysis (SVA). A company can chose one of these four for their company's economic framework of the future. The choice will have a substantial effect on management resources, strategy choices, and on how investors, analysts, media, etc view the company. This paper will deal with EVA and CVA, the two most frequent concepts in Sweden. Many things are being said about the two frameworks. I will in this paper present my reflections on a few similarities and differences of the two frameworks. In section 2 I will briefly discuss Value Based Management in general. Section 3 discusses the parts of the CVA concept that is necessary for the comparison with EVA. Section 4 discusses the parts of the EVA concept that is necessary for the comparison with CVA. Section 4 will also discuss whether EVA functions as a Value Based Management concept (which is its objective) or just another version of accounting. Section 5 will discuss the alleged necessity, for technical reasons, of basing a Value Based Management tool on accounting which EVA does, contra the possibility of basing it directly on Cash Flow which CVA does. Section 6 further compares EVA to CVA and it discusses the final corrections that are necessary to eventually have EVA become a concept that simulates cash flow. Section 7 will discuss the Market Value Added concept, and then we have the conclusion in section 8. In Appendix 1 I will discuss a company's concept of value from the shareholders' perspective. All figures, graphs and tables in the paper are my own. I will leave out some interesting aspects in order to keep this paper a paper and not a book, e.g. the problems that we find in accounting's consolidation of multinational corporations, i.e. consolidation effects from inflation and currency effects, which also influence the quality of EVA.

1 Introduction

VALUE BASED MANAGEMENT: Economic Value Added or Cash Value Added?

What we use today to follow up a company's profitability and value creation is inconsistent with the capital market's mechanism, and what the market considers determines value (further explained in Appendix 1). That is why we have what is called Value Based Management (VBM). VBM is what we should use instead of accounting for internal financial management. Accounting will still be used to calculate tax and to control the company from the legal perspective. Inside companies, to understand and manage our business, we use VBM. Management, controllers, engineers, and other people in a company that are in touch with economic issues should never use accounting simply because it does not improve the quality of their work 3 . I have in figure 2.1 illustrated a company in what I call the "Company Golf Course". I try to illustrate the company with its two most important frontiers, the one towards its owners (Stock market) and the one towards the company's customers. To the left on the golf course we have the Business Reality, i.e. the activities that actually takes place in reality. We need to manage those activities so that our owners' value is maximized. We must then be able to bridge the activities at the left, the Business Reality, to how the market wants us to view it. I believe it is only possible to do that if we simulate ("Financial Simulation of Business Reality") the Business Reality using the capital market's mecha Fredrik Weissenrieder, 1998 3 http://www.anelda.com

2 Value Management

Based

nism. We will then obtain relevant knowledge from our financial illustration of Business Reality. That will give us the relevant feedback we need to improve the activities in the company's Business Reality. The Business Reality's border line towards the capital markets' mechanism (the gray vertical line) can easily be abused, as accounting abuses it today with the usage of P&L and balance sheets. We then have little or no chance of achieving the knowledge that is necessary to manage our company the way we should manage it. We will become greatly misinformed if we stand on the border, looking at the Business Reality using "improper glasses". Our company will be managed by using something else than Value Based Management as the large arrow down to the right, pointing to the left, tries to illustrate (we lose our connection to the stock market). The company's so-called Strategic Feedback Loop will not function. The Strategic Feedback loop is the continuous evaluation of strategies where they are evaluated using information from the strategies to make necessary adjustments in the strategy. There seems to be an infinite amount of examples in companies where the Business Reality's frontier does not work the way it should and can do, but rare are the examples where the frontier functions the way it should and can. The Financial Simulation of the Business Reality must of course be based on Discounted Cash Flow as concluded in the appendix

Business RealityMarketing Intellectual Capital Logistic s

Financial Simulation of Business RealityProductivity Improvement Operating Cash Flow Economic Life

Financial Markets' RealityValue Creation

Customer Loyalty

C U S T O M E R S

Capital Cost Cus tomer Satisfaction TQM

Pre-strategy Value Simulations

CVA Value Drivers

Strategy Value Simulations Investor Relations R&D Real Options Investment Behavior Capital Allocation

Pricing Strategy Product Mix Flexibility Improvement

SIL Operating Efficiency Strategic Investments Capital Structure

S T O C K M A R K E T

?Figure 2.1; the "Company Golf Course"

Accounting: Profit/share P/E-ratios, Re , ROCE,

A true VBM framework is consistent with the market's mechanism and our four factors that, according to the market, determine value (Appendix 1). It must be simple but correct. In order to further increase our knowledge about how to increase shareholder value we must be able to simulate, view, and analyze our business from this perspective - the Financial Markets' Reality. Our Investor Relation function should be used to make sure that the company is priced correctly from the new perspectives VBM gives us. All this can be accomplished by structuring the business reality by e.g. using the Balanced Scorecard concept and link this to the relevant VBM framework of our choice. Fredrik Weissenrieder, 1998 4 http://www.anelda.com

The consulting market contributes four basic frameworks for VBM As I mentioned earlier I will only focus on EVA and CVA in this paper.

4

: EVA 5 , CVA6 , CFROI 7 and SVA

8

.

3 CVA and the concept of Strategic InvestmentsCVA (Cash Value Added) is a Net Present Value model that periodizes the Net Present Value calculation and classifies investments into two categories, Strategic and Non-strategic Investments tegic Investments are those which objective is to create new value for the shareholders, such as expansion, while Non-strategic Investments are the ones made to maintain the value the Strategic Investments create. A Strategic Investment (e.g. in a new product or an investment in a new market etc) is followed by several Non-strategic Investments. A Strategic Investment can be in a tangible or an intangible asset; the traditional view of whether an outlay of cash is an investment or not does not matter here. What we believe in our company to be a value creating cash outlay is what we then should define as a Strategic Investment. The Strategic Investments form the capital base in the CVA model because the shareholders' financial requirements should be derived from a company's ventures, not chairs and tables (which accounting's capital base consist of and instead e.g. disregards Strategic Investments in intangibles). That means that all other investments with the purpose of maintaining the original value of the venture must be considered as costs, such as buying new chairs and tables. So how is the capital base calculated in the CVA concept? A so-called OCFD is calculated from each Strategic Investment (which is the first factor of our four factors that determines value) made in the company. The aggregate of every Strategic Investment's OCFD in a business unit is the business unit's capital base. The OCFD is calculated as the cash flow (which is the second factor of our four factors that determines value), equal amount in real terms every year, that discounted using the proper capital cost (which is the fourth factor of our four factors that determines value) will give the investment a Net Present Value of zero over the Strategic Investment's economic life (which is the third factor of our four factors that determines value). The OCFD is a real annuity but adjusted for actual annual inflation (not the average inflation). The OCFD must be covered by the Operating Cash Flow (OCF), which is the cash flow before Strategic Investments but after Non-strategic Investments, in or Software der for the Strategic Investment to create value. All of this is easily structured in a CVA The OCFD is not in any way a prediction of what the future OCF will be. It is a constant benchmark for the future cash flows (and historic cash flows since these analyses can be made for historic as well as for future analyses as can be seen in table 3.2). The OCFD is "fixed" in real terms over the investments economic life to illustrate the financial logic. Our understanding of how our company's, or business unit's, cash flow is relate to that can be called business logic. It is difficult, and sometimes impossible, to understand our business logic if we do not have the, in real terms, fixed benchmark, as d we will see in the analyses made later in this paper. A Strategic Investment creates value if the OCF (see below) exceeds the OCFD over time. This can be presented as: + Sales -Costs = Operating Surplus +/- Working Capital Movement - Non-strategic Investments = Operating Cash Flow - Operating Cash Flow Demand = Cash Value Added (CVA)Table 3.1 Fredrik Weissenrieder, 1998 5 http://www.anelda.com11 9

. Stra-

10

.

The Cash Value Added (CVA) represents the value creation from the shareholders' point of view. This can be expressed using monthly, quarterly, or yearly data. It can also expressed as an index:Operating OperatingEquation 3.1

Cash Flow

Cash Flow Demand

= CVA Index

The CVA Index can be split up into four margins (in relation to sales):

Operating Surplus margin - WCM margin - Non - strategic Invest ment margin Operating Cash Flow Demand margin CVA IndexEquation 3.2

=

These, together with sales, form the CVA concept's five major Value Drivers:Sales Equation 3.3

Operating

Surplus

Sales

-

Working Capital Movement Sales

-

Non - Strategi Investmen c t Sales

s

-

OCFD Sales

= CVA

Table 3.2 shows a simple example of what a CVA calculation could look like in a company. It is an example with only one Strategic Investment of 100. The Operating Cash Flow Demand is calculated as the cash flow that will give the investment of 100 a Net Present Value of zero over the economic life of 11 years and with a capital cost of 15%. Inflation is 3%. Tax can be included in the cash flow or in the WACC, which is done here.1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Sales 160 170 250 185 200 215 200 Costs -150 -155 -220 -160 -170 -180 -155 Operating surplus 10 15 30 25 30 35 45 Working Capital Movement 0 -1 -6 5 -1 -1 1 Non-strategic investments -1 -3 -1 -3 -12 -4 -3 Operating Cash Flow 9 11 23 27 17 30 43 Operating Cash Flow Demand 17 18 18 19 19 20 20 21 22 22 23 Cash Value Added -8 -6 5 8 -2 10 23 CVA Index 0,53 0,64 1,29 1,42 0,88 1,51 2,11 Average discounted CVA Index: 1,10 Strategic investments -100 Cash Flow -100 9 11 23 27 17 30 43 0 0 0 0 Table 3.2

CVA is a concept solely based on cash flow, not even an opening balance using the current or adjusted balance sheet is used which is common in other so-called cash flow models (those are of course not true cash flow models). There is, of course, much more to this concept (it is an entire financial management concept) but this is sufficient to be able to compare the framework to the EVA. The Cash Value Added discussed in this paper has been developed in Sweden by Erik Ottosson and Fredrik Weissenrieder, see Ottosson and Weissenrieder (1996). It should not be confused with The Boston Consulting Group's Cash Value Added. Boston Consulting Group's CVA is a development of their Cash Flow Return on Investment (CFROI) concept. The two models are not similar in their fundament, i.e. the way the models calculate the return and value of a business, or how they present their result. They have unfortunately, though, been named using the same three words, but that is the only similarity. Fredrik Weissenrieder, 1998 6 http://www.anelda.com

4 EVAEVA (Economic Value Added) is a model based on a company's accounting. Its mechanism is therefore like accounting: Sales - Operating Expenses Tax = Operating Profit =EVATable 4.1

Financial Requirement

EVA's capital base is formed by the company's (or unit's) balance sheet:

Balance Sheet Year XFigure 4.1

X

WACC

=

Financial Requirement

Example: MSEK 1994 1995 1996 1997 (budget) Sales 234 258 305 420 Operating Expenses 1 2 Tax 0 -3 -10 -28 Operating Profit 34 50 52 107 Financial Requirement -45 -50 -60 -62 EVA -11 0 -8 45Table 4.2

-200 -205 -243 -285

The "Financial Requirement" is calculated as the defined capital (an adjusted balance sheet) multiplied with a suitable WACC: MSEK 1994 1995 1996 1997 (budget) Capital 375 417 500 520 WACC 12% 12% 12% 12% Financial Requirement 45 50 60 62Table 4.3

Bennett Stewart has identified several errors made in accounting from the investor's perspective. He therefore adjusts these in order to simulate cash flow. Which adjustments must be made in order to simulate a cash flow situation? Examples are general and specific shortcomings in Accounting such as 1 3 : Inventory costing and valuation Depreciation Revenue recognition Capitalization and amortization of R&D, marketing, education, restructuring charges, acquisition premiums Fredrik Weissenrieder, 1998 7 http://www.anelda.com

Bennett Stewart has identified a total of 164 adjustments and corrections. This amount will probably be different from country to country. There is, of course, much more to this concept but this is sufficient to be able to compare the framework to the CVA. There is software developed for EVA

14

.

4.1 EVA's corrections - Do they work in practice?EVA claims to be a Value Based Management framework, but is it? That will depend on how well the framework manages to simulate the "Business Reality" (in figure 2.1) from the shareholders' perspective, i.e. the "Financial Markets' Reality". To do that, EVA must make several adjustments in accounting. I strongly question the possibility of obtaining this in practice, and even if it is possible to make all 164 corrections/adjustments it will still not function well enough. That is the issue this paper discusses. EVA is implemented in companies for mainly two reasons: 1) Its objective is to increase the organization's knowledge of the company and the understanding of the financial implications of its processes, which will improve decision making which, in turn, will increase the value of the company. 2) It is easy to understand. EVA's ability in number one will be discussed in the remaining part of this paper, after this section, but the second one "it is easy to understand" will be dealt with here. Yes, EVA is easy to understand but wha is it the organization understands? Consider the following illustration, the "Circular Reference" in t figure 4.2:

23The company inserts the investments and cash flows into different accounts because of the external legal requirement. Management gets the legal requirement confused with economic reality. The firms book keeping is not readjusted towards cash flow. The economic information is instead further battered by legal requirements and illustrated using P&L statements and balance sheets.

1

Here is the capital market's reality: investments, cash flow, economic life and capital cost. This is where value and profitability should be measured. DCF models are therefore applied here. All companies' economic data can be derived from here.

4Economic information has now turned into traditional accounting. Management is no longer able to measure profitability or value.

"Cash Flow"

5 6163 corrections/adjustments are made. Here, EVA uses so-called straight-line depreciation. Bennett Stewart starts the long way back. At least 164 corrections/adjustments are necessary if the "cash flow" point of the circle is to be restored.

7 EVA and so-called annuity depreciation.EVA, as it is today, does not get any further with its 164 corrections/adjustments. At least two more adjustments are necessary. Those will be dealt with in section 6 of this paper. Figure 4.2; the "Circular Reference"

The logic behind figure 4.2 is that all companies have cash data to begin with. It is then put into the economic framework used today at companies, i.e. accounting. The company will be at the far right when the accounting process is finished. EVA's mission is to take us all the way back again because


8


it is onl at the point to the left that we are able to, in financial terms, simulate the company's Business y Reality from the shareholders perspective. 4.1.1 Not enough adjustments are carried out Companies that implement EVA are recommended to make about 5-15 corrections/adjustments. How far do you think they travel on the circle? Not very far. Sometimes they travel even less because fewer corrections/adjustments than 5 are made. Sometimes only 1! This is the strongest reason for why I claim that EVA cannot be used for Value Based Management. As we will see later in section 6, an additional 1 or 2 corrections/adjustments suggested in this paper will substantially change the information from EVA, how much different then will not the information from EVA with another 160 or so corrections/adjustments be. But which adjustments should we be making to adjust EVA all the way to the left of the circle? That is 15 : always a difficult question to answer. Bennett Stewart comments on this "We recommend that adjustments to the definition of EVA be made only in those cases that pass four tests: it likely to have a material impact on EVA? Is Can the managers influence the outcome? Can the operating people readily grasp it? Is the required information relatively easy to track or derive?" Not many corrections/adjustment can pass all of these tests, which is the reason for why only a few corrections/adjustments are made in reality. Some further comments to these four tests: "Is it likely to have a material impact on EVA?" - An adjustment might have a material impact on EVA but does it improve the quality of EVA or will it only further confuse us? My opinion is that we cannot know this without doing a cash flow based analysis (CVA) to have as a benchmark. This is why not many adjustments will pass this test. "Can the managers influence the outcome?" - Managers can (from the financial perspective) usually only influence what is Business Reality, i.e. Strategic Investments, their cash flow and economic life. They can do that no matter how we choose to illustrate the impact of these (accounting, EVA, CVA). They are likely to be influencing these in the future, no matter which concept we choose for the future; accounting, EVA or CVA. The concepts are here to help us illustrate Business Reality as best as we can. It is only then that we can achieve the necessary knowledge of our business. I believe it is imperative to then make sure that they see the few things they actually can influence; Strategic Investments, their cash flow and economic life. Business Reality transparency is then essential. No mysterious bundle of periodizations or non-cash items. This is why not many adjustments will pass this test. "Can the operating people readily grasp it?" - My experience is that operating people, especially technicians, have difficulties with accounting to begin with since they work with the company's Business Reality. If we on top of that start making adjustments, which will be difficult to explain to nonaccountants, we are out on thin ice. On the other hand, another experience I have is that e.g. technicians enjoy discussing Business Reality i.e. investments (Strategic or Non-strategic), their economic life and the cash flow they need to produce in the future to be profitable. Finance to them must be that clear and simple because it is not their core knowledge, especially not accounting's version of it. We cannot require that everyone knows accounting. This is why not many adjustments will pass this test. "Is the required information relatively easy to track or derive?" - This is probably the most difficult test. How do we e.g. adjust for actual economic life of our assets in the balance sheet, a very important adjustment? For old assets it means that we must go far back in history and make adjustments. We must also change our current assets' historic and present depreciation method, which is not easy, etc, etc. Not many adjustments will pass this one. It will be much easier to implement CVA compared to making these adjustments. Fredrik Weissenrieder, 1998 9 http://www.anelda.com

I understand why adjustments must pass these four tests. EVA will not be possible to implement in real life if the ambition is set higher than that. This is unfortunate, because my opinion is that the concept is not too bad in theory, but just like accounting in real life. 4.1.2 Irrelevant issues are discussed The company's dialogue must be focused on the point to the far left in figure 4.2, the cash flow point, because it is the only point on the circle that is Business Reality. The process from left to right must be left to people not involved in any financial or strategic evaluation or decision making because that process on the circle will not enhance the organization's knowledge about the situation at the far left, which is the point they must learn and understand. The only concern management should have about that process is whether it is being done or not and that it is being carried out in a proper way for control and tax reasons. The information management receives for decision making must be derived from models that only handles the point to the far left - Discounted Cash Flow models. Why spend time and resources on anything else but the cash flow point and why spend time on readjusting a process that never should occur for any other reasons than the legal ones (control and tax)? Why not instead focus on the simple and few factors that determine value and profitability; investments, cash flow, economic life and capital cost? We can also identify a hazard in using EVA. Managers today are known to not act on information from accounting, much because they do not see the relevance in it. Management's intuition concerning Business Reality play a large role in companies today because the lack of relevance in financial information. Managers in companies that implement a poor version of EVA might be lead to believe the quality of information has been substantially improved which might have negative consequences. They might act on information that is accounting in disguise. Companies implement EVA because it is easy to understand. It is easy to understan because they d understand what they always have been working with, i.e. the accounting process. This is not, however, what an organization should try to understand because they have then understood something that is not very relevant for managing a company. The objective of Value Based Management is not to further understand accounting but instead to increase the understanding of the point to the far left and its implication on shareholder value, and nowhere else on the circle - we do not need to understand accounting better than we already do. On the contrary, most people in an organization probably need to know it less than they do today. Again, EVA is not too bad in theory, but just like accounting in real life. EVA might be easy to implement because it is "Accounting Reality". It can be implemented in the way most accounting systems can, i.e. the organization is given new directives which they blindly follow. CVA is the border between the Business Reality and the Financial Reality. The implementation is an interactive process between the people active in the Business Reality (technicians, controllers, etc) and the ones active in the Financial Reality (Company Headquarter, owners' representatives etc). The implementation of CVA might therefore be perceived as being more difficult than implementing EVA because it requires more attention from the organization. This attention is however the attention necessary (and wanted) in order to reach the level of change in the organization towards Shareholder Value.

5 EVA instead of Cash Flow?EVA is a concept based on a company's Profit&Loss statements and balance sheets so it is based on accounting, not cash flow. I'm sure Bennett Stewart would agree with me on what determines value, i.e. the relationship between investments, the cash flow they generate, the economic life of those and their capital cost. So why does he choose a method that is based on accounting and not cash flow? 16 We can read the following in Bennett Stewart's book : Fredrik Weissenrieder, 1998 http://www.anelda.com

10

Abandon Cash Flow! However important cash flow may be as a measure of value, it is virtually useless as a measure of performance. So long as management invests in rewarding projects those with returns above the cost of capital - the more investment that is made, and therefore the more negative the immediate net cash flow from operations, the more valuable the company will be. It is only when it is considered over the life of the business, and not in any given year, that cash flow becomes significant." In other words, he writes that the Net Present Value concept is useless unless we can discount the investment's/project's complete cash flow over it's completed economic life. I would have agreed with him a few years ago because it was true before the CVA concept was developed. The CVA concept, however, periodizes the Net Present Value calculation into years, quarters, months or the time period of the user's choice and not one entire period as a traditional Net Present Value calculation does. It is then possible to use it for measuring performance and profitability, so even though his statement was true when it was written, it isn't any longer. This can be illustrated using the following (nominal) example. It can be an IT company, Wal-Mart, Hennes&Mauritz or any other fast growing company with heavy negative cash flows due to profitable growth; I therefore call the company in the example "H&M/Wal-Mart" (tax is assumed to be included in the WACC):Cas h Flow at H&M/Wal-Mart1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 SI 1 -1,400 238 245 252 260 268 276 284 293 301 311 320 329 339 350 360 371 SI 2 -1,400 238 245 252 260 268 276 284 293 301 311 320 329 339 350 360 SI 3 -1,400 238 245 252 260 268 276 284 293 301 311 320 329 339 350 SI 4 -1,500 255 263 271 279 287 296 304 314 323 333 343 353 364 SI 5 -1,500 255 263 271 279 287 296 304 314 323 333 343 353 SI 6 -2,000 340 350 361 372 383 394 406 418 431 444 457 SI 7 -3,000 510 525 541 557 574 591 609 627 646 665 SI 8 -3,500 595 613 631 650 670 690 710 732 754 SI 9 -4,000 680 700 721 743 765 788 812 836 SI 10 -4,500 765 788 812 836 861 887 913 CF -1,400 -1,162 -917 -764 -487 -702 -1,323 -1,263 -1,101 -834 4,541 4,678 4,818 4,963 5,111 5,265 5,423

Table 5.1

The assumptions above are that one, or a number of, stores (SI:s) are opened each year and they are estimated to each have an economic life of 20 years. The last H&M/Wal-Mart store therefore closes in 2009, according to our assumptions. For simplicity, I have chosen to have the same capital cost of 15% for every store. I also say that the inflation is 3% every year and that the stores earn the same amount of money every year in real terms. Also, to make it simple, I say that the stores produce a cash flow of 17% of the investment sum the first year which then increases with inflation in the following years. If we look at the net cash flow of H&M/Wal-Mart we can see that it is negative. We cannot stand in 1987 or in 1993, look at the "CF" line and say "So, how are we doing". The question and its answer if one comes up, are not very relevant. So far, I agree with Bennett Stewart. EVA will therefore go into H&M/Wal-Mart's P&L statement and balance sheet and after about 164 adjustments produce the following figures 1 7 :

5.1 EVA at H&M/Wal-Mart1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Operating Cash Flow18

238 483 736 1,013 1,298 1,677 2,237 2,899 3,666 4,541 4,678 4,818 4,963 5,111 5,265 5,423

Financial Requirement 280 550 809 1,077 1,334 1,680 2,211 2,820 3,502 4,254 4,073 3,891 3,710 3,528 3,347 3,165 Economic Value Added -42 -66 -73 -64 -36 -3 26 80 164 287 605 927 1,253 1,583 1,918 2,257 "EVA Index" 0.85 0.88 0.91 0.94 0.97 1.00 1.01 1.03 1.05 1.07 1.15 1.24 1.34 1.45 1.57 1.71

Table 5.2 Fredrik Weissenrieder, 1998 http://www.anelda.com

11

The EVA model claims that it can, by the use of existing accounting, tell us what the profitability of the company as a whole has been from the beginning to whatever year we have complete figures for (here 1996). We have a steady growth in presented profitability over the years, from an EVA of -42 in 1981 to an EVA of + 2 257 in 1996. We also introduce, for the sake of the analysis, a new measure that we can call the "EVA Index". It is simply the Operating Cash Flow divided by the "Financial Requirement" 19 . If the Index is 1.00 we meet our requirement, if it is below 1.00 we don't, and if it is above 1.00 we return a cash flow above the requirement. We can see that it wasn't until 1987 that we became profitable according to EVA. 5.1.1 EVA at store no 6 EVA tells us that the profitability (i.e. the difference between the Operating Profit and the Financial Requirement) of store number 6 up to 1996 has been increasing as we can see in graph 5.1. The first three years were not good enough but the trend now seems very positive.600 EVA's Operating Profit, store no 6 EVA's Financial Requirement, s tore no 6

500

400

300

200

100

0

Graph 5.1

Graph 5.2 tells us that the investment ended up as a success in the remaining years under the assumptions we made. Expansion in identical investments will be heavy on profitability for three years but will be extraordinarily profitable after that. Managers in the early years will be looked upon as managers struggling with profitability while the managers in the later years will be looked upon as being very successful. The managers of this store are generously rewarded if bonus is based on the change of EVA over time.


12


600 EVA's Operating Profit, s tore no 6 EVA's Financial Requirement, s tore no 6 500

400

300

200

100

0

Graph 5.2

This will be reflected also at the aggregated level, the parent, since all investments made make the 5.1.2 EVA at the parent same amount of money in relation to the investment sum. The heavy growth will show poor profitabilty This will be reflected also at the aggregated level, the parent, since all investments made make the same amount of money in relation to the investment sum. The heavy growth will show poor profitability for a number of years but the company will show profitability in year 1987 as presented in graph 5.3. Profitability boosts after the expansion is stopped in 1990. Again, the management responsible for the expansion will probably not be looked upon as certain heroes while the ones that stopped it probably will. If bonus is based on the change of EVA over time, the ones receiving bonus after 1991 (probably a new management) will be heavily rewarded while the ones before 1991 will be rewarded to a much lesser degree.

7 000 6 000 5 000 4 000 3 000 2 000 1 000 0

EVA's Operating Profit, aggregated level EVA's Financial Requirem ent, aggregated level

Graph 5.3 Fredrik Weissenrieder, 1998 13 http://www.anelda.com

Graph 5.4 will further establish this picture. Profitability is further increased as time passes. The first store is closed down in 2001 and after that one is closed each year. In 2009, only one store remains and that one is closed down that year. The success factor here, according to EVA, is to avoid expansion.7 000 6 000 5 000 4 000 3 000 2 000 1 000 0

EVA's Operating Profit, aggregated level EVA's Financial Requirement, aggregated level

Graph 5.4

5.2 CVA at H&M/Wal-Mart1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Operating Cash Flow 238 483 736 1,013 1,298 1,677 2,237 2,899 3,666 4,541 4,678 4,818 4,963 5,111 5,265 5,423 Operating Cash Flow Demand 189 383 584 804 1,030 1,331 1,775 2,301 2,909 3,603 3,711 3,823 3,937 4,056 4,177 4,303 Cash Value Added 49 100 152 209 268 346 462 599 757 938 966 995 1,025 1,056 1,087 1,120 CVA Index 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26 1.26

Table 5.3

CVA does not include the Strategic Investments (the expansion) in the cash flow but will instead activate those using the Net Present Value method. I.e. it does not measure profitability at the "CF"-line in table 5.1. The CVA concept periodizes the Net Present Value calculation, spreading the required Present Value, based on each Strategic Investment in a business unit, over the investments' economic lives. The CVA concept uses the same original figures as the EVA concept did, that is from table 5.1, but the conclusion will be different. Now, H&M/Wal-Mart will show profitability from the start in 1981! The profitability will be the same over the chain's existence, 1.26 in CVA Index (OCF/OCFD). This is because CVA introduces a fixed financial requirement, the so-called Operating Cash Flow Demand. We create this "Demand" from the Strategic Investments we make, here the 10 stores. One OCFD from each store, they can be looked upon separately or at an aggregated level. The Operating Cash Flow Demand is the cash flow that is needed in order to end up with a Net Present Value of zero when the investment has reached its economic life. The Operating Cash Flow from each investment is the same in real terms every year. The Operating Cash Flow Demand of H&M/Wal-Mart will grow, in nominal terms, for two reasons; the growth in the number of stores until 1990 and the inflation adjustment every year of the existing stores' Operating Cash Flow Demand.


14


5.2.1 CVA at store no 6 This can be seen in graph 5.5 where both the Operating Cash Flow and the Operating Cash Flow Demand increases by inflation. Here, managers will probably be viewed upon equally over the period.600 CVA's Operating Cash Flow, store no 6 500 CVA's Operating Cash Flow Dem and, store no 6

400

300

200

100

0

Graph 5.5

The next graph, graph 5.6, illustrating the completed economic life will give us the same information, which is that the investment has the same profitability over time and that it is profitable from year 1. Growth in this concept will be rewarded from the first year.600 CVA's Operating Cash Flow, store no 6 500 CVA's Operating Cash Flow Demand, store no 6

400

300

200

100

0

Graph 5.6


15


5.2.2 CVA at the parent Graph 5.7 gives us the situation up until 1996 for the parent, H&M/Wal-Mart. The chain of stores expands heavily and the expansion shows profitability all the way.

7 000 6 000 5 000 4 000 3 000 2 000 1 000 0

CVA's Operating Cas h Flow, aggregated level CVA's Operating Cas h Flow Demand, aggregated level

Graph 5.7

This expansion is however stopped in 1991 but managers at the beginning of the company's life will be viewed equally as the ones at the end. As they should (apart from the fact that they, if possible, should keep on expanding). The same amount of money is made from each store (in relation to the investments made) over the company's life. CVA illustrates that. I believe it is important to have an economic framework that reflects Business Reality.

7 000 6 000 5 000 4 000 3 000 2 000 1 000 0

CVA's Operating Cash Flow, aggregated level CVA's Operating Cash Flow Demand, aggregated level

Graph 5.8 Fredrik Weissenrieder, 1998 http://www.anelda.com

16

5.3 EVA compared to CVA at H&M/Wal-MartThe two VBM concepts EVA and CVA can easily be compared. First, take a look at store 6's presented CVA and EVA respectively in graph 5.9. Here the concepts' different signals are very clear. EVA is rapidly increasing over the years while the CVA increases with inflation. Note that the Net Present Value of the EVA equals the Net Present Value of the CVA. If you were a manager whose bonus was based on the change in EVA or CVA from year to year, which concept would you w antto have implemented (for the bonus reason)? EVA of course. Your bonus would probably be substantial every year, even though store no. 6 makes the same amount of 2 0 ! Bennett Stewart writes 21 that bonus should be based on the change money every year in real terms in EVA from year to year which in this case, and in all other cases where straight-line depreciation is 22 used, would be unfortunate . Bennett Stewart's concept will, unless profitability is heavily decreased, reward the management who chose to implement EVA, but for the wrong reasons because the shareholders will not be rewarded. Business Reality has not shown any improvement.500 CVA, s tore no 6 EVA, store no 6 400

300

200

100

0

-100 Graph 5.9

Graph 5.10 shows us the total effect from each of the two concepts. EVA will show lower profitability in the beginning but much larger after half time compared to CVA. This despite the fact that each investment made makes the same amount of money in relation to the investment sum every year in real terms. Again observe that the Net Present Value's of the two concepts are exactly the same. The managers at H&M/Wal-Mart would become quite wealthy if EVA was used at their company and bonus was based on the change of EVA over time. Especially the ones who worked at the company after the expansion was stopped.


17


4 000 CVA, aggregated level EVA, aggregated level 3 000

2 000

1 000

0

-1 000 Graph 5.10

Well, does this matter? Surprisingly many managers and controllers seem to be just fine with this situation. They might say, "well, no, because all that matters is future cash flow any ways" which is of course true but to say that our historic reflection of our company does not matter would be like saying that company experience does not matter. Also, to say that we are not influenced by historic information would of course not be true either. Picture the two, out of several, following "others held equal" scenarios: 1. Was the reason why H&M/Wal-Mart stopped expanding in this case due to the fact that the expansion period showed poor profitability using EVA? It must of course be possible to see that expansion is value creating if that is the case! 2. What if the profitability had been substantially lower, e.g. corresponding to a CVA Index of 0.70? EVA would still show excellent profitability in the later years and expansion plans would surely be presented. The expansion plans here would in more ways than one be influenced by the excellent profitability given to us by the generous EVA concept. There is much room for mistakes in this situation. - It must of course be possible to evaluate a business' profitability even if it is old and written off in the accounting system! EVA will in these cases hinder us from expansion when we create value and instead trigger us to expand when we destroy value. The answer to the question asked earlier "does it matter" seems to be "yes". If we isolate the concepts' capital bases at Store 6, the Operating Cash Flow Demand in CVA and the Financial Requirement in EVA, we get the picture presented in graph 5.11. As expected, EVA's Financial Requirement falls rapidly while it increases (by inflation) in CVA. I should point out that EVA's Financial Requirement would fall even quicker if depreciation was put into Operating Profit instead of the Financial Requirement as is normally done. This will be further examined in 5.4.


18


600 CVA's Operating Cash Flow Demand, store no 6 EVA's Financial Requirem ent, store no 6 500

400

300

200

100

0

Graph 5.11

At the aggregated level we get the following picture, shown in graph 5.12. EVA's Financial Requirement decreases from year 1991 when the expansion is stopped. CVA's Operating Cash Flow Demand increases in nominal terms (however equal in real terms) until the first store is closed down, then it decreases with the closing down-rate. Still, the Net Present Value of CVA's Operating Cash Flow Demand equals the Net Present Value of EVA's Financial Requirement, but only in 1980. After 1980 will the Net Present Value of CVA's Operating Cash Flow Demand not equal the Net Present Value of EVA's Financial Requirement. Management must decide how they want their company to be presented internally and externally because the accounting way of doing things will not be taken for granted in the future.7 000 CVA's Operating Cash Flow Demand, aggregated level 6 000 5 000 4 000 3 000 2 000 1 000 0 EVA's Financial Requirem ent, aggregated level

Graph 5.12


19


It is of further interest to study the indexes. Companies that use EVA, as far as I know do not use what I here call the EVA Index. In a way, that is unfortunate because the Index in the CVA concept has turned out to be useful in many situations and for different reasons. On the other hand, using the EVA Index would not be a good idea as we are about to see. Graph 5.13 shows us the development of the different concepts' Indexes up until 1996. Here we have two EVA Indexes. EVA Index 1 puts depreciation into the Financial Requirement, as has been done earlier in this case, while EVA Index 2 puts it into the Operating Profit which is done in reality. The CVA Index presents the same profitability every year (1.26) as can be expected under the assumptions we made about this case, but the EVA Indexes do not. EVA Index 1 shows improved profitability but EVA Index 2 shows even steeper improvement. This is because the difference I analyse here between EVA and CVA is enhanced if we do with the EVA concept as most companies do - i.e. put depreciation into the Operating Profit instead of the Financial Requirement. This, as we can see, has turned out to be a mistake by the ones that use the concept. What I believe to be the large error made by the EVA concept in the capital base (as previously explained in 5.1-5.3) is heavily leveraged if depreciation is put into Operating Profit. However, this is what happens in accounting with measures like ROCE, ROOC, R and ROI because the EVA Index e equals conceptually all those measures, especially the ROCE (some say that they are identical since all adjustments made in EVA can be made in ROCE the only difference is that ROCE is a measure expressed in percentages while EVA is expressed in absolute numbers). Those measures are very volatile and highly unreliable. I should point out that even though the EVA Indexes 1 and 2 are different here, the calculated EVA's are the same no matter where you put depreciation. This means that if you stick to the EVA in absolute numbers, which is the difference between the Operating Profit and the Financial Requirement, and do not calculate a EVA Index, which is the relation between them, you will not run into this situation (apart from the fact that you will have the wrong idea about your capital base which is highly unfortunate). On the other hand you miss out on a highly useful tool - the Index.2,50 CVA Index, s tore no 6 EVA Index 1 (depreciation in "Financial Requirement"), store no 6 EVA Index 2 (depreciation in "Operating Profit" com parable with ROCE), store no 6

5.4 The leverage

EVA

2,00

1,50

1,00

0,50

0,00 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Graph 5.13


20


The overall picture, over the store's full economic life, is presented in graph 5.14. EVA Index 2 reaches astronomic figures in the end, just as ROCE would present profitability.35,00 30,00 25,00 20,00 15,00 10,00 5,00 0,00 CVA Index, store no 6 EVA Index 1 (depreciation in "Financial Requirement"), s tore no 6 EVA Index 2 (depreciation in "Operating Profit" - comparable with ROCE), s tore no 6

Graph 5.14

Graph 5.15 illustrates H&M/Wal-Mart's total profitability up until 1996. The CVA Index will always be the same every single year in a business that in real terms makes the same amount of money in relation to the Strategic Investments made to create the business. The level of the EVA index will not be based on that. The direction of EVA's profitability in relation to the investments made to create it will depend on if the business is expanding (as it is here to begin with) if inflation changes etc, etc, instead of showing true profitability.2,50

CVA Index, aggregated level EVA Index 1 (deprec iation in "Financial Requirement"), aggregated level

2,00

EVA Index 2 (deprec iation in "Operating Profit" - c omparable with ROCE), aggregated level

1,50

1,00

0,50

0,00 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Graph 5.15

The profitability in this simple H&M/Wal-Mart example is changing because the business is expanding heavily to begin with, and EVA presents it as being unprofitable at that point. It then presents it as being profitable just because the expansion ends. That is the only reason why EVA changes over time in this example. Is this how we want to present profitability? Fredrik Weissenrieder, 1998 21 http://www.anelda.com

H&M/Wal-Mart generates the exact same amount of money every year! Why then, as in graph 5.16, measure its financial performance as if it was increasing?35,00 30,00 25,00 20,00 15,00 10,00 5,00 0,00 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009Graph 5.16 CVA Index, aggregated l evel EVA Ind ex 1 (depreciation in "Fi nancial Requiremen t"), aggregated level EVA Ind ex 2 (depreciation in "Operating Profi t" - comparable with ROCE), aggregated level

Some say that these errors in accounting/EVA are "cancelled out" or self-adjusted since a company continuously makes investments, i.e. that the EVA curves in 5.16 are pushed down to where the CVA Index is. It is my experience that this is a comment that arises when the person in question no longer can explain the relationships between investments made and the cash flow they produce. The fact that the errors in accounting, from the investors point of view, are cancelled out does to begin with not improve the situation conceptually - what has caused what and why? Also, I think that the only way we can find out if errors have been cancelled out or not is to compare EVA curves with something that does not have the accounting's errors, e.g. to use the CVA curve as a benchmark. We must until then live with uncertainties such as is my ROCE of 14% actually 4% and my EVA of 100 actually 100. The distribution of accounting based measures as ROCE and EVA around true profitability is wide too wide to grasp or ever understand.

6 Completing Reference"

the

"Circular

Some of you may think that EVA and CVA seem similar. In theory they are, but not in reality. They are similar in theory because CVA stands to the very left in the circle, figure 4.2, which is the point of the circle EVA tries to get to, so of course they are similar in theory. As we all know, however, only a few corrections/adjustments are made so in reality we will not travel very far, if at all, on the circle. They are therefore not similar in real life. But lets say that we actually made all the corrections/adjustments that are necessary in order to simulate an operating cash flow (which is EVA's Operating Profit but without the depreciation which instead is put into the Financial Requirement). Also, we adjust EVA's Financial Requirement to be a requirement that is solely based on investments made. We make all 164 corrections/adjustments. Economic life equals actual economic life, the Financial Requirement is calculated using opening balance (which is a balance totally free from everything that should not be there, i.e. a balance that consists only of actual investments made and still in use), etc., etc. Do we then close the circle? Almost, but a couple of adjustments are still necessary.


22


Lets go through those last adjustments using a (nominal) example. The investment of 2,000 in the example below has an economic life of 12 years. The WACC is 15% and estimated inflation is 3%. The Operating Profit (here defined as the Operating Surplus adjusted for Working Capital, WC, movements but without depreciation) is a bit volatile so it does not increase with inflation as in the H&M/Wal-Mart example. This unit experiences four investments after the initial investment is made. Those are activated into the balance sheet. Those are normal investments that are necessary to maintain the value and economic life of the unit as was planned/estimated in the decision process for the initial investment. A major investment is almost always followed by investments that are made (have to be made) because the major investment was made.Year: 0 1 2 3 4 5 6 7 8 9 10 11 12 Strategic investment 2 3 -2,000 Operating surplus + WC movement 300 450 450 600 900 700 600 800 600 400 300 200 Non-strategic investments 2 4 -150 -200 -250 -300 Cash Flow -2,000 150 450 250 600 650 700 300 800 600 400 300 200 Table 6.1

These are everything we need in order to do both CVA and EVA. CVA would look like this:Year: 0 1 2 3 4 5 6 7 8 9 10 11 12 Operating Cash Flow 150 450 250 600 650 700 300 800 600 400 300 200 Operating Cash Flow Demand 327 337 347 358 368 379 391 402 414 427 440 453 CVA -177 113 -97 242 282 321 -91 398 186 -27 -140 -253 Table 6.2

The Operating Cash Flow equals Operating Surplus adjusted for Working Capital movements minus Non-strategic Investments. The Operating Cash Flow Demand is the cash flow that is necessary each year (the same cash flow in real terms every year) to give the Strategic Investment a Net Present Value of zero 2 5 . The CVA is the difference between the Operating Cash Flow and the Operating Cash Flow Demand. CVA has classified the investments that follow the initial investment of 2,000 as being "value maintaining" investments, not value creating. They have in other words not added extra value to the business. This does not mean that it is useless to make investment calculations to evaluate those (even though they usually hav to be made). However, the Net Present Value calculated will not be a value e that is added to the business if the Non-strategic Investment is carried out. It is instead the value that will be lost from the initial investment if it is no carried out. This is of course in many aspects the t same thing but I believe it to be essential to realize that the Net Present Value a calculation generates not always means that new value has been added to the company and therefore for the shareholders. Value is added to a company when a strategic decision is taken (if it has a positive Net Present Value, of course), not when decisions are taken to preserve a strategy's value.

6.1 CVA vs. EVA using straight line depreciation EVA using straight line depreciation would look like this:Year: 0 1 2 3 4 5 6 7 8 9 10 11 12 Operating Profit 300 450 450 600 900 700 600 800 600 400 300 200 EVA's Financial Requirement 467 494 465 505 470 522 449 515 428 386 295 261 EVA -167 -44 -15 95 430 178 151 285 172 14 5 -61 Table 6.3

Again, the Operating Profit consists of Operating Surplus adjusted for Working Capital movement. The Financial Requirement is calculated as each year's opening balance of the fully adjusted balance sheet, which includes the four investments since they are investments in large tangible assets, multiplied with the WACC plus that year's depreciation. It cannot be better than it is in table 6.3 if straightline depreciation is used. We can see in graph 6.1 that CVA and EVA, straight line depreciation, are not very similar, even though we have made a large number of adjustments. I claim that CVA is at the far left of the circle, Fredrik Weissenrieder, 1998 23 http://www.anelda.com

figure 4.2. We then, obviously, need to make further adjustments in EVA because this situation is not acceptable. Consider, though, that this is a very good and precise situation for EVA compared to EVA in real life.500 400 300 200 100 0 01 234 56789101112 -100 -200 -300 Graph 6.1

CVA EVA, straight line depreciation

We can see in graph 6.2 that the Operating Cash Flow Demand behaves as we can expect it to do. It increases with inflation (3%) because it is only based on the Strategic Investment. A so-called Strategic Marginal Investment 2 6 could occur in real life, which would increase the size of the capital base, and hence the Operating Cash Flow Demand, but that has not occurred here. EVA's Financial Requirement jumps however up and down in a seemingly random manner. This business and its annual balance sheets are fairly isolated which enables us to make further analyses of EVA's Financial Requirement in graph 6.3.

700

CVA's Operating Cash Flow Demand EVA's Financial Requirem ent, straight line depreciation

600

500

400 300

200

100

0 123456789101112 Graph 6.2 Fredrik Weissenrieder, 1998 24 http://www.anelda.com

Graph 6.3 analyses EVA's Financial Requirements further. The requirement from each of the five investments included in the capital base is rapidly falling, as can be expected from EVA using straight line depreciation. It is clear that we cannot have a Financial Requirement that decreases like this, although it has always been like this in accounting. Bennett Stewart, together with others before him, has identified this. He therefore suggests using the annuity method (sinking-fund depreciation) for the Financial Requirement.EVA's Financial Requirement from Non-s trategic Inves tment 4, straight depreciation EVA's Financial Requirement from Non-s trategic Inves tment 3, straight depreciation EVA's Financial Requirement from Non-s trategic Inves tment 2, straight depreciation EVA's Financial Requirement from Non-s trategic Inves tment 1, straight depreciation EVA's Financial Requirement from Strategic Investm ent, straight depreciation

700

600

500

400

300

200

100

0 1 234 5678 9101112

Graph 6.3

6.2 CVA vs. depreciation

EVA

using

annuity

We now use the annuity method for calculating EVA's Financial Requirement. Annuity means that the Financial Requirement will be the same every year in nominal terms just like annuity payments to a bank on a mortgage. I.e. it will decrease by the inflation rate in real terms. It may initially be difficult to see in graph 6.4, but EVA is now much closer to CVA.Year: 0 1 2 3 4 5 6 7 8 9 10 11 12 Operating Profit 300 450 450 600 900 700 600 800 600 400 300 200 EVA's Financial Requirement 369 414 414 473 473 548 503 593 533 533 458 458 EVA -69 36 36 127 427 152 97 207 67 -133 -158 -258 Table 6.4


25


500 400 300 200 100 0 01 2345 6789101112 -100 -200 CVA EVA, annuity method -300 Graph 6.4

The reason for why EVA looks more like CVA is found in the Financial Requirement (because the Operating Profit has not been changed), graph 6.5. CVA's Operating Cash Flow Demand is unchanged but EVA's Financial Requirement has changed substantially.

700

CVA's Operating Cash Flow Dem and EVA's Financial Requirement, annuity method

600

500

400

300

200

100

0 123456789101112 Graph 6.5

We can further analyse EVA's Financial Requirement as in graph 6.6. Here it is clear that substantial changes have been made.


26


700

600

EVA's Financial Requirement from Non-s trategic Investment 4, annuity depreciation EVA's Financial Requirement from Non-s trategic Investment 3, annuity depreciation EVA's Financial Requirement from Non-s trategic Investment 2, annuity depreciation EVA's Financial Requirement from Non-s trategic Investment 1, annuity depreciation EVA's Financial Requirement from Strategic Investment, annuity depreciation

500

400

300

200

100

0 123456789101112

Graph 6.6

I would like to point out that the initial investment of 2,000 is in reality probably depreciated over 10 years in accounting, and not over 12 years as in this example. The only remaining asset in the capital base would then be the fourth Non-strategic Investment. This is something that must be adjusted for every asset if EVA is to function. Otherwise profitability will suffer even more at the beginning of a project and be even better at the end than it automatically already does in EVA (as was shown in 5.4). If I have understood Bennett Stewart's EVA concept correctly, this is as far as they take it. As the circle (figure 4.2) tries to illustrate, they have not reached the point at the far left yet. Two more adjustments are necessary in my opinion, which I do not think has been discussed in the EVA concept.

The first of the two adjustments that I want to add concerns the so-called Non-strategic Investments. Why would we want to put our "chairs and tables" into our Financial Requirement? A company's owners will never walk into the company, point at a table and ask "how much money have you made on this table this year?" The question is irrelevant in most companies. An owner is interested to find out 2 7 . Still we have our chairs and tables in accounting and which strategies create value and which don't EVA's Financial Requirement. Some may disagree with me on this, but why let accounting principles instead of Business Logic command us on what we consider to be an investment. Bennett Stewart is very right when he claims that some costs, like some R&D and marketing, should be considered to be investments and then be activated. The same thinking should lead to that some payments, that are today considered to be investments, are in actual fact costs. Traditional accounting has an industry-focused view on what an investment is. The confusion brought upon us in today's environment, where an cash outlay in a machine is far from enough to reach success in selling a product or service on a global market, has many faces. "Hidden values" are suddenly found in companies and companies rush into the quest for the value of intangibles or intellectual capital instead of initiating a change of the company's fundamental economic framework. Is it really a surprise that companies often make their money from investments not represented by the balance sheet? Hopefully not. The construction of the balance sheet is lead by accountants and ruled by law, not Business Reality or Business Logic. The discussion about a company's total strategic assets (tangibles and intangibles) is relevant and important but must be much more structured and focused on relevant issues. An example of the confusion is when companies identify the value of the intangibles or the intellectual capital as the difference between the value of the company at the stock market and the (corrected/adjusted) equity. Fredrik Weissenrieder, 1998 27 http://www.anelda.com

6.3 CVA vs. EVA, 1

st

adjustment

Owners of a company should be concerned over statements like that. It indicates that the company's knowledge about Business Reality (figure 2.1) has not been tied to the Financial Markets' Reality, which surely will lead to sub optimization of the company's strategic assets (tangibles and intangibles) and to inefficient and costly capital allocation. A few comments to the example in the previous paragraph: The reasoning would e.g. result in a higher perceived value of intangibles or intellectual capital if an expansion is stopped or if inflation rises (as explained in section 5). This is due to the, from the investors' perspective, technical error in accounting's reflection of the Financial Markets' Reality and should not have any effect on management's view on Business Reality. Not only do they confuse an asset "at cost" (the equity) with an asset "at value" (the intangible or intellectual capital) but also would the value of a company's (corrected/adjusted) equity be unchanged if the value if the intangibles or intellectual capital were to become zero? Of course not. Neither would the value of the intangibles or intellectual capital (if measured as the stock market value minus the equity) remain the same if all computers, desks and telephones were thrown out of a bank or an insurance company. The value of a company is created by a confluence of strategic assets, fixed and non-fixed. Fixed and non-fixed - goes together like a horse and carriage. This is the relationship management must understand. Only then have they tied Business Reality to the Financial Markets' Reality. Bringing in accounting's investment concept only enhances confusion. Unfortunately this happens in most companies today. An effective VBM concept structure the strategic assets to a capital structure that will include both tangibles and intangibles and the concept will make no difference between the two. The capital will be "at cost" and the discussion on the capital structure's (the strategic assets') valu will become more relevant. The comparison with a stock market value must be handled with caution. This e because is the stock market value will not only include the Present Value of current strategic assets (the Prestrategy Value, figure 2.1) but also the Net Present Value of the Strategic Investments that lie in the future (the Strategy Value, figure 2.1). The Net Present Value of those future Strategic Investments can be both positive and negative (a Net Present Value of zero in the average stock market company).s t adjustment (Non-strategic Investments are put into the Graph 6.7 compares EVA, annuity method, 1 operating cash flow instead of being activated) to CVA and the picture is much better than graph 6.4.

500 400 300 200 100 0 012345 6789101112 -100 -200 CVA EVA annuity method, 1st adjustm ent -300 Graph 6.7 Fredrik Weissenrieder, 1998 28 http://www.anelda.com

The Financial Requirement will then look even more like CVA's Operating Cash Flow Demand as we can see in graph 6.8. It is now clear to us what the next adjustment must be.700 CVA's Operating cash flow demand EVA's Financial Requirement, annuity method, 1s t adjustment 600

500

400

300

200

100

0 123456 789101112 Graph 6.8

Why have a Financial Requirement whose level and movements are dependent on inflation? EVA's Financial Requirement, using the annuity method and after the adjustment we just made, will "fall and rise" with inflation. It will decease with the inflation rate every year. It seems to me that the nominal annuity method that EVA uses here assumes that inflation is 0%. Wouldn't probably 1% be a better estimate and then an improvement? If it is, why not try to improve the estimate? Graph 6.9 has "inflated" EVA's Financial Requirement and turned it into a real annuity. EVA will then be identical with CVA, as we should expect.500 400 300 200 100 0 01 234567 89101112 -100 -200 -300 Graph 6.9 Fredrik Weissenrieder, 1998 29 http://www.anelda.com

6.4 CVA vs. EVA, 2

nd

adjustment

CVA EVA, 2nd adjus tment

We made the change in Financial Requirement that we discussed, we inflated it with actual inflation, so it will be identical to CVA's Operating Cash Flow Demand.700 CVA's Operating Cas h Flow Demand EVA's Financial Requirement, 2nd adjustment 600

500

400

300

200

100

0 1234 567 89101112 Graph 6.10

We have now closed the circle, figure 4.2.

6.5 Further real analysis of the concepts' capital basesI have in this section made a simple real analysis to further clarify the differences between CVA's and EVA's capital bases and to analyse the effect of different economic lives on the capital base. Assumptions are as before; an investment of 2,000, an inflation of 3% and a nominal capital cost of 15% (a real capital cost of 11.7%) will give us the real figures for EVA and CVA as presented in table 6.5. I have, again, put the depreciation into the Financial Requirement to get a fair picture and to make the comparison possible. The differences of an economic life of 20 years are illustrated in graph 6.11. The most common version of EVA, EVA with straight line depreciation, puts a heavy burden on the business in the early years and a very low burden in the late years. An investment that makes e.g. 300 in cash flow per year in real terms will be presented as unprofitable in the early years and extremely profitable in the later years. Despite the fact that it produces the same amount of cash flow every year, EVA will never when comparing any two years, in this case show anything but improved profitability. We can also express the Financial Requirement in percent. If we assume that 262 corresponds to a nominal capital cost of 15%, then EVA straight line depreciation requires 22% the first year and 4% in the last year, an unwheighted average of 11.6%, not 15%. The Internal Rate of Return will however be 15%, but that will not be measured or presented in EVA. The average Financial Requirement will then have shifted from 15% to 11.6%! The business will on the average be presented as being substantially more profitable than it should be presented, just as accounting. EVA, using annuity method, requires 18% in the first year and 10% in the last year, an unwheighted average of 13.6%. The Internal Rate of Return will also here be 15%. I do not think that this will improve the operative personnel's understanding of a company's capital base. CVA's Operating Cash Flow Demand and EVA using an inflation adjusted (real) annuity will both require 15% every year. The Net Present Values are the same for each curve.


30


Years: 1 2 19 20 EVA's Financial Requirement, straight line depreciation 388 363 74 64 EVA's Financial Requirement, annuity depreciation 310 301 182 177 EVA's Financial Requirement, inflation adjusted annuity depreciation 262 262 262 262 CVA's Operating Cash Flow Demand 262 262 262 262 Table 6.5

400 350 300 250 200 150 100 50 0

EVA's Financial Requirement, s traight line depreciation EVA's Financial Requirement, annuity depreciation EVA's Financial Requirement, inflation adjusted annuity depreciation CVA's Operating Cash Flow Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Graph 6.11

As I wrote earlier in 5.3, EVA will trigger us to avoid expansion when it is profitable and to expand when we shouldn't. Who wants to invest under these circumstances? Profitability will be low in the early years if we e.g. make 300 per year and we then actually produce sufficient cash flow. On the other hand, in year 17-18 will calls for a replacement be raised? The business might only be able to give us a cash flow of 150 per year but this investment will be presented as being very profitable under those circumstances. This will undoubtedly have an effect on management's decision. One can always argue that the Operating Cash Flow generated from a Strategic Investment should be higher in the beginning when the product is competitive and lower at the end when it is less competitive. EVA's Financial Requirement, straight line depreciation, would then reflect this pattern. This would however be an unfortunate mix up between an investment's Financial Logic and its Business Logic. The knowledge we have, that a certain investment makes more in the beginning, is our Business Logic and can only be obtained if we separate it from the Financial Logic. The Financial Logic is the, in real terms, constant benchmark, which enables us to obtain our Business Logic, a true Business Logic reflecting Business Reality and a Financial Logic reflecting the Financial Markets' Reality. We will not be able to obtain that knowledge if we measure the investment as being equally profitable over its economic life, an "EVA Index" of 1.00, as EVA would in this case. Is this picture dramatically improved if we have an economic life of 10 years instead? No. As we can see in graph 6.12 we still find a high requirement from the common EVA even if it does look a bit better than before. We can also here express the Financial Requirement in percent. If we assume that 349 corresponds to a nominal capital cost of 15%, then EVA straight line depreciation requires 21% the first year and 7% in the last year, an unwheighted average of 13.7%, not 15%. EVA using the annuity method requires 17% in the first year and 13% in the last year, an unwheighted average of 14.6%. CVA's Operating Cash Flow Demand and EVA, using inflation adjusted annuity, will both require 15% every year. The Net Present Values are the same for each curve. Fredrik Weissenrieder, 1998 31 http://www.anelda.com

Years: 1 2 9 10 EVA's Financial Requirement, straight line depreciation 485 443 199 171 EVA's Financial Requirement, annuity depreciation 387 376 305 297 EVA's Financial Requirement, inflation adjusted annuity depreciation 349 349 349 349 CVA's Operating Cash Flow Demand 349 349 349 349 Table 6.6 500 450 400 350 300 250 200 150 100 50 0 EVA's Financial Requirement, straight line depreciation EVA's Financial Requirement, annuity depreciation EVA's Financial Requirement, inflation adjusted annuity depreciation CVA's Operating Cash Flow Dem and 01 23456 78 910 Graph 6.12

If we have an economic life of only 5 years as in graph 6.13 the picture will be further improved but EVA's Financial Requirement will not be corrected. We can also here express the Financial Requirement in percent. If we assume that 550 corresponds to a nominal capital cost of 15%, then EVA straight line depreciation requires 19% the first year and 11% in the last year, an unwheighted average of 14.6%, not 15%. EVA using the annuity method requires 16% in the first year and 14% in the last year, an unwheighted average of 14.9%. CVA's Operating Cash Flow Demand and EVA using an inflation adjusted annuity will both require 15% every year. The Net Present Values are the same for each curve.

Years:12345 EVA's Financial Requirement, straight line depreciation 680 603 531 462 397 EVA's Financial Requirement, annuity depreciation 579 562 546 530 515 EVA's Financial Requirement, inflation adjusted annuity depreciation 550 550 550 550 550 CVA's Operating Cash Flow Demand 550 550 550 550 550 Table 6.7


32


700

600

500

400

300

200 EVA's Financial Requirement, straight line depreciation 100 EVA's Financial Requirement, annuity depreciation EVA's Financial Requirement, inflation adjusted annuity depreciation 0 012345 Graph 6.13 CVA's Operating Cas h Flow Demand

7 Market Value Added - MVAThe goal of a company's Value Based Management (and Shareholder Value) process is to make the shareholders as wealthy as possible, but how is that measured? Bennett Stewart and his company Stern&Stewart have introduced a measure called Market Value Added. Bennett Stewart writes "Shareholders' wealth is maximized only by maximizing the difference between the firm's total value and the total capital that investors have committed to it. We call this difference Market Value Added, or MVA: MVA = Total Value - Total Capital" The total value is the market values of debt and equity. The Total Capital is the adjusted total assets from the balance sheet. It is adjusted according to the EVA concept.

28

:

MVA Total Value (Market Value)

Total Capital

Figure 7.1

Examples from the Swedish Stock Exchange MSEK Market Value Capital MVA MVA Index AssiDom n 21,000 20,000 1,000 1,05 Astra 166,000 44,000 122,000 3,77 Ericsson 142,000 85,000 57,000 1,67 Incentive 32,000 29,000 3,000 1,10 Stena Line 2,000 4,000 -2,000 0,50 Volvo 99,000 100,000 -1,000 0,99 Hufvudstaden 7,000 2,000 5,000 3,50Table 7.1 Fredrik Weissenrieder, 1998

29

:30

33


Stern&Stewart frequently have listings published in many countries of the current MVA rating. These are often discussed in companies as something important and relevant, but are they? I agree with Bennett Stewart on the fact that shareholder's wealth is maximized only by maximizing the difference between the firm's total value and the total capital that investors have committed to it. One thing we cannot do, however, is to define the Total Capital as something from a company's balance sheet. I here want to refer to all previous sections of this paper that discusses the weakness of the balance sheet and especially the section on tangibles and intangibles in 6.3. In table 7.1 we find some Swedish companies. We know (without using the MVA) that some of those create value and some do not. We also know how much because we can measure it by looking at the stock development + dividends over time, which is the total return to the shareholders. So, does the MVA increase our knowledge or understanding? If the balance sheets used as the defined capital were adjusted for everything that we must adjust for when using EVA, then we would have a measure that may increase our understanding of the company in question. We must then make at least the 164 adjustments Bennett Stewart suggests. We must adjust the assets' time period, in which they are depreciated over, for actual economic life. We must use real annuity, etc, etc. We must travel all the way back on the circle 4.2. We will not often see developments in balance sheets so extreme as the one we saw in graph 5.14. It will look more like the development in graph 5.15 where additional investments are carried out. So, you might think, what does my company's balance sheet look like in a graph like this? Well, I am afraid the answer is "we will never know". The example in section 5 presents a highly theoretical situation. It is a situation that is easy to analyse from EVA's point of view because the balance sheet is "clean" in the sense that it only consists of the depreciated remains of actual investment made in new stores, nothing more and nothing less, and the time period they are depreciated over equals actual economic life. In reality, the asset side of the balance sheet is a mess from a non-accounting point of view. It will not only consist of depreciated remains of actual (Strategic) Investments made in stores. It will also include items such as Non-strategic Investments, advances to suppliers, prepaid expenses and accrued income, inventories and supplies, etc, etc. Some randomly chosen assets will be (incorrectly, of course) adjusted for market values, etc. The time periods the assets are depreciated over will not equal actual economic life. The balance sheet will also leave out all Strategic Investments made in intangibles discussed in 6.3. The list can be made very long which is exactly what Bennett Stewart has done listing the possible adjustments in the EVA concept. These "errors" from the non-accounting point of view will appear very different from one company to another, from one line of business to another. Some of the major differences will depend on if it is a local or multinational corporation, if the company's assets have long or short lives (one company could look like graph 6.11 another like 6.13), if the company is expanding or not, if it has been expanding in earlier years or not, etc, etc and finally, of course, how the company chooses to present the balance sheet over time. Again the list can be made very long and companies can therefore not be compared using the balance sheet as one of the components (or a balance sheet with less than at least 50-100 large and relevant corrections/adjustments). The "Capital" in an MVA calculation must be a fully adjusted balance sheet, any other capital would make no sense in a calculation together with a market value. Since it is not possible to obtain information on the corrections/adjustments necessary to make, in order to close the circle for the balance sheet in figure 4.2, those are not made. MVA listings are therefore not relevant and must be dismissed. They do not increase our knowledge or understanding, on the contrary. Also, a company's balance sheet illustrates the investments made to generate the business as we see it today. In other words, it is the capital base for the Present Value of the future cash flow that will be generated from the business if no further Strategic Investments are made. The market value, however, is the sum of the Present Value of the future cash flow from the business without any further Strategic Investments and the Net Present Value of the cash flow from future Strategic Investments. The market values the company's ability to produce positive (or negative) Net Present Values in the future. An MVA does therefore not present a value added of the business today, it also includes the Fredrik Weissenrieder, 1998 34 http://www.anelda.com

Net Present Value of the companys future business. We compare apples with oranges. A financial management concept must naturally be able to separate those two values. The "punch-line" here is the Hufvudstaden case. Hufvudstaden is an old real estate company that owns some of Sweden's most beautiful (commercial) estates. Hufvudstaden's MVA is extremely good. This should come as a surprise to all of us because if you know the Stockholm Stock Exchange you know that Hufvudstaden has destroyed shareholder value for the last 15 years because the stock is 31 . It has not moved much over time, so is valued at about the same value as it was 15 years ago Hufvudstaden's MVA really so great or is the ranking the result of a model unable to measure what it tries to measure? By this time the question can easily be answered. Hufvudstaden's assets are often written off or almost written off and inflation has done a terrific job on the rest of the assets. The MVA of Hufvudstaden seems to make no sense what so ever because the "Total Capital" is in this case obviously irrelevant. Despite its size (much larger than many other companies on the MVA listings) Hufvudstaden is never included in any MVA listings. Everyone with knowledge about the Stockholm Stock Exchange would dismiss any MVA listing with Hufvudstaden at the top half. The irrelevance of MVA becomes very obvious in the Hufvudstaden case, it is not as obvious in other companies, which however doesn't make the ranking of those less irrelevant. The MVA listings have the same problems with al companies in the listings that it has with Hufvudstaden to a greater or lesser degree . Ho wever, l we do not know to what degree for any of the companies! This makes the listings, in my opinion, totally irrelevant. What would the ranking be if all of these "errors" from the investors' perspective were adjusted? We'll never know. Also, the long-term average of all companies' MVA's put together will be zero but this never seem to be the case in the rankings presented. This is because the investors' opportunity cost of capital for the stock market is the return from a weighted portfolio of all companies on the stock market (also the companies' cost of equity, but not adjusted for specific risk). There are usually only a small amount of companies that show negative MVA's. This is a strong indication on that there are severe miscalculations in the MVA listings. Companies must therefore work to maximize the total return to the shareholders, i.e. the shares' value increase + dividends, not the MVA.

8 ConclusionNow I want to rise the obvious question. Why travel on the circle, figure 4.2, from the point to the far left, all the way to the right, just to go all the way back again - from the point we began our trip? We were there from the beginning, so why don't we stay there from the very beginning? As I pointed out in section 5, it was not possible to measure historic profitability and value in incompleted businesses from that point on the circle before CVA was developed. But now it is developed and is being implemented in Swedish multinational corporations. They will have a strategic and operational tool solely focused on Strategic Investments (tangible and intangible), their cash flow, their economic life and capital cost. Nothing more, nothing less. They will be able to tie the company's Business Reality to the Financial Markets' Reality (figure 2.1). Figure 8.1 tries to illustrate a Value Based Management process. Three already existing functions must be improved if the Value Based Management is to be a success. The process is a success if the total return to the shareholders (share value + dividends, not MVA as discussed in section 7) increases. 1. A correctly focused Value Based Management concept has the organization focusing on the relevant issues. It will be based on the four factors that determine value; Strategic Investments (tangibles or intangibles), the operating cash flow they generate, the Strategic Investments' economic lives, and their capital cost. My experience is that it is crucial for the strategic dialogue that the process is not disturbed by any irrelevant issues but instead gets a chance to focus on the relevant. Today with accounting, some relevant issues are discussed, many irrelevant issues are included while many relevant are excluded because accounting is not focused on the four factors Fredrik Weissenrieder, 1998 35 http://www.anelda.com

that determine value. EVA might improve this, but then to a limited extent (depending on the ambition of the EVA implementation) so it will still be based on accounting and the issues accounting triggers. EVA is not too bad in theory, but just like accounting in real life. This was mainly dealt with in section 4.1. 2. A Value Based Management concept based on financial theory will give the company the possibility to increase the quality of the financial analyses made at the company (the possibility will turn into ability when the company's knowledge within value theory and Value Based Management is increased). EVA might provide the company with slightly better analyses but the quality will, in my opinion, be far away from what it will be if the ambition is set higher than what realistically can be achieved with EVA. This was dealt with in sections 5 and 6. 3. The two functions will have an effect on the intrinsic value of the company, which in the long run will have an effect on the market value. If the company wants the intrinsic value of the company to over time equal the market's valuation of the company, then also the Investor Relations function must be Value Based. The company should e.g. communicate issues like the company's capital allocation (where are Strategic Investments made?), investment strategies in the company's business groups, information on the company's profitable growth areas, analysis of the company's Operating Cash Flow (the components), etc. Much like the Swedish company SCA is starting to do. Some analysts and media might not immediately observe this new information since they not observe the markets mechanism today, i.e. discounted cash flow. That will however only be a matter of time because more and more of those now turn towards the discounted cash flow view.

Value Based Management 1. Improved internal dialogue Increased Intrinsic value 3. Value Based Investor Relation 2. Improved numeric analyses

Increased market valueFigure 8.1; the Value Based Management process

Company's must now identify the VBM concept that will best fulfil this process (figure 8.1) for the company in the future. Most company's I have discussed this with agree with me that discounted cash flow will fulfil the process better than some concept that is based on a company's P&L statement and balance sheet. Some company's will still chose EVA instead of CVA because they today have low ambitions with their VBM process. If a company's ambition within Shareholder Value is set low then EVA comes in handy. Making a few (1-10) corrections/adjustments in accounting is easy. If our ambitions are set higher so that we need to make more corrections/adjustments (>20) we might as well, from an effort point of view, implement CVA. CVA requires some initial work when the company's financial management is re-established into cash flow (but surely less work than making ~20 adjustments in EVA) but will after the implementation is made be much simpler to use than EVA. Fredrik Weissenrieder, 1998 36 http://www.anelda.com

Some EVA advocates may say "we keep it simple, EVA is all we need to know". It is simple because it is just like accounting, which is the framework we know today. Accounting is, however, what we now say we want to step away from. CVA is also simple - if you have some knowledge within corporate finance. CVA focuses on the relevant issues while EVA doesn't, and CVA is much more correct than EVA is so I do not agree on the statement "EVA is all we need to know". We cannot be content with EVA if our ambition concerning the quality of information from our VBM process is high or if we have a high ambition on changing the organization towards understanding the meaning of the expression Shareholder Value, only if it is low. In other words, if we want to travel more than ~10% on the circle (figure 4.2) by correcting/adjusting accounting then we are much better off implementing a concept that is based on the cash flow point to the left to begin with. Then we do not have to make any adjustments in

ssrn id156288 eva,cva dcf

Documents