The Wall Street Journal Interactive Edition -- February 13, 1997

Allocation Theory EVA: The Latest Economic Elixer

By ROGER LOWENSTEIN

Staff Reporter of THE WALL STREET JOURNAL

If nothing else, it has been fun to watch "economic value added" spread like the latest elixir. Stern Stewart, a New York consulting firm, trademarked EVA as a tool for measuring business performance. In recent years, the firm has been increasingly successful, like some, though not all, of its clients -- and far from shy about talking up its success. EVA has become a buzzword: You can almost hear the just-converted chief executive confide to his peer, "We're going on EVA." And the listener will nod, and will detect that his rival is joined to the great crusade for shareholder wealth, and will probably make a mental note to get with the program himself. Among those already there: Coca-Cola Co., Eli Lilly & Co., Quaker Oats Co. and AT? Corp. Lately, EVA has made a further advance -- into the realm of investing. After all, if it can help managers better allocate their companies' capital -- and it seems to have helped some -- why shouldn't it help you, the investor, allocate yours?

Growing Usage

No less than Fortune magazine dubbed it, in the title of an article, "A New Way to Find Bargains." Recall that old investment yardstick, earnings per share? It's losing ground to EVA, the magazine gushed. Though that is pushing it, research analysts at Credit Suisse First Boston Corp. now include EVA along with earnings, sales, cash flow, return on equity and accumulated frequent-flier miles as investment tools. Michael Mauboussin, the investment bank's EVA maven, has lectured investors in Hong Kong, London, Frankfurt, New York and even Buffalo, N.Y., to rapturous receptions. Goldman, Sachs & Co. is on board, too. The intriguing idea behind EVA is to express in a single number two concepts: net profit and rate of return. EVA equals a company's profit less what it would have earned with an "expected" return on capital. If a company's target is 10%, you expect $100 on $1,000 of capital. If it in fact earns $120, it has added $20 of EVA. Stern Stewart has protected its turf in part by tinkering with definitions of profit, in ways that are by turns sensible and dubious. (It regards, for example, Coca-Cola's advertising not as an expense but as an "investment." I could quibble, but either way Coke will earn a lot of money and a lot of EVA.) But its main point is that only the profit above the expected hurdle rate "counts.

" New Wine? There is everything sensible and nothing new in the idea that capital has an implicit cost -- an opportunity cost -- and that it is the return on capital that matters. You would rather deploy $1 million in a project likely to earn 20% than invest a larger sum and make 6%. But total profit also counts. So if you could invest a lot more and still expect, say, 18%, you would do it. If companies hire Stern Stewart to rebottle this old wine, no one is much the worse. And if that's what it takes to get certain managers thinking about rates of return, and to design incentives so that employees will do the same, so be it. Joel Stern, a partner in the firm, a former student of Milton Friedman and a devotee of Chicago-school economics, makes rather a grander case. "EVA gives you the hurdle rate," he says, whereas heathens outside his tent "don't have a method for capturing it in a single number." Simple Concept Perhaps that is because no one number can do it. Stern Stewart's formula is based on the capital-asset pricing model, an academic theory according to which the stock market is a perfect machine that predicts -- in the form of price volatility -- the exact hurdle rate for every stock beneath the heavens. A stock that in the past was twice as volatile as the average supposedly proffers twice as much added return over Treasury bills. Unfortunately, academics have shot the theory full of holes. Jay Ritter, a University of Florida professor who keeps up with such matters, says, "The theory is compelling, the evidence is abysmal." (Query for First Boston and Goldman: If they are touting a formula that assumes an efficient market -- meaning stock prices are ever right and the market ever unbeatable -- why not fire their analysts and be done with it?) But without EVA, what hurdle would one use? In the words of Jack Ciesielski, publisher of the Analyst's Accounting Observer, "the cost of capital is one of the unsolved riddles of finance." Debt costs whatever interest rate you pay, but what does equity cost -- or rather, what return on it is required? One must rely on judgment and horse sense. A chief executive officer should certainly strive to beat the average return in his industry. But over time, he should be thinking about whether his industry is sufficiently profitable -- and if it isn't, redeploying capital elsewhere, or letting shareholders do it for him. This may be imprecise, but it conforms to decisions in the real world. When Coke entered China, it wasn't because a sign on the Great Wall said, "Thirty Percent on Capital." Rather, Coca-Cola knew its return in emerging markets was much higher than what shareholders could expect in most other businesses. And that was enough. I am all for the right incentives, and it is nice that Coca-Cola pays cash bonuses on profits above a hurdle rate. It is also irrelevant -- because Coke, like some others who talk the talk, awards immense stock options with no hurdle rate. In 1995, Coca-Cola Chairman Roberto Goizueta got options on one million shares at the market price. If the stock rises 5% a year, he makes $36 million; at 10% a year (still less than Coke's 11% hurdle rate), $91 million. As for using EVA as an investment tool, it's a good idea -- if you can't divide. Warren Buffett remarked of EVA at his company's 1995 annual meeting: "I don't think it's a very complicated subject... . I didn't need [it] to know that Coca-Cola has added a lot of value."