What happened to the buzz about economic tools? Some alternative valuation methods have become mainstream
'I have one simple request. And that is to have sharks with fricken laser beams attached to their heads! Now evidently my cycloptic colleague informs me that is a bad idea and cannot be done. (Slams fist on table) Can you remind me what I pay you people for? Honestly!' – Dr Evil, chief executive of multi-national crime syndicate in the film, Austin Powers: International Man of Mystery.
The fiendish doctor was a little out of touch with economic reality. Having emerged from 30 years in suspended animation, he threatened to wreak global havoc unless the world community handed over a less-than-staggering $1 mn. Moreover, his shark and laser project, while conceptually compelling, seemed an inefficient allocation of capital. Fortunately, his management team was able to point that out as well as suggest inflation-adjusted demands.
Perhaps they were using economic analysis tools such as CFROITM or EVATM. These valuation methods, along with a host of others with attractive acronyms, all purport to remedy problems with traditional accounting measures for both investors and corporations. While not entirely new ideas, these 'alternative' valuation methodologies were defrosted in the 1980s and firmly placed into the spotlight in September 1993 when Fortune magazine published a description of the EVA (economic value added) concept along with anecdotal reports about successful corporate implementations. The theme in that article and the torrent that followed was that EVA adoption led to better stock performance. In one ad, EVA purveyor Stern Stewart claimed, 'Forget EPS, ROE and ROI. EVA is what drives stock prices.' Not surprisingly, companies and investors flocked to learn the gospel from consultants.
Since then however, the buzzwords of economic value seem less frequently heard. Has the fervor cooled in favor of more traditional accounting measures? Not quite. As the concepts are becoming more ingrained, the jargon is merely becoming more understated.
'Most companies have implicitly accepted that this is the way to allocate capital,' according to Joe Joseph, managing director at Putnam Investments. 'But a lot of the buzz has gone because it has been incorporated into expectations. You don't talk about this thing anymore. It is taken for granted that this is the way you are doing it.'
It is hard to find numbers on just how deeply the doctrine of economic value metrics has penetrated into the investment and corporate communities. However, there are some indications that the phenomenon has yet to peak. Stern Stewart counts about 250 companies around the world as clients and figures an equal number of companies have implemented a version of EVA on their own. For its part, Chicago-based Holt Value Associates says its CFROI (cash flow return on investment) framework is used by 2,200 portfolio managers and buy-side analysts to manage $1.3 trillion in equities. Fueled by the growth of international investment, the ideology is spreading worldwide, with major companies – both public and state-owned – adopting the methodology.
Yet while economic measures are seen as 'The One True Way' by a large number of users in the corporate and fund management communities, there remain holdouts. 'The market moves on earnings, earnings momentum and cash flow,' states Joel Ray, a CFA and assistant director of research and managing director at First Union Securities. 'But I haven't heard a lot of discussion on EVA – at least in the health care sectors that I follow.'
'You don't follow one valuation scheme anymore,' adds Daniel Boone, senior partner at Atlanta Capital, a firm with some $6 bn under management. 'You use multiple valuations to generate risk/reward models and probabilities. CFROI and EVA are helpful concepts but they do not capture everything. The results for people using them are mixed. There is no Holy Grail out there in terms of valuation.'
Shaken, possibly stirred
Well, it may not be the silver bullet of measurement, but does economic analysis work in terms of corporate performance? Its advocates in the consulting community sure say so – if done right. A study of Stern Stewart's EVA clients indicates they provide total shareholder returns substantially higher than those of competitors. On average, investments in the shares of Stern Stewart clients produced almost 50 percent more wealth after five years than equal investments in peer group companies. The results are even more impressive for firms that used the complete Stern Stewart compensation architecture.
'We divided clients into three groups,' explains Bennett Stewart, senior partner at Stern Stewart. 'The first group did not use EVA for compensation purposes. The second group used EVA in determining incentive rewards but inserted it in a more traditional bonus plan where EVA targets were set by budget negotiations and bonuses capped. The third and largest group went the full way – and did best. The more a company fully adopted EVA, the more they tended to outperform their peer group.' Stewart says that investment for five years in the shares of the third group produced some 85 percent more wealth than equal investments in their competitors.
Indeed, for investors, tying economic metrics to compensation is the acid test of a company's commitment to the program. 'In the early 1990s when people really woke up to the concept, you saw two types of companies – those that actually believed in this and those that used it as a buzzword. You could tell the difference if a company's compensation was tied to EVA,' states Putnam's Joseph.
Joseph, a stalwart convert to the CFROI methodology, adds that some companies may use economic metrics, yet still underperform. 'You can adopt it and use it to manage your capital but that still doesn't guarantee you will not lose competitive position,' says Joseph. 'It is just a tool for looking at how you allocate capital. If underperforming companies] didn't adopt it, maybe they would have performed even worse.'
'There are several keys to the process,' notes Mike McConnell, senior vice president for client services at Holt Alliance Services. 'First is the extent that it can be driven into the organization. More important, is whether the programs derived from a value perspective are linked to compensation. If you don't pay people for results, it dies. Still more important is top management's commitment to it.'
On the investment side, indications of commitment are mixed. It is commonly held that the sell-side still views the world mostly in terms of accounting-based performance metrics. Transaction-oriented, it is said they push their research in terms familiar to investors. However, Bennett Stewart disagrees, pointing to major investment houses like CS First Boston and Goldman Sachs as 'lead steers' in the EVA revolution. 'The large sell-side firms are the ones asking to know more about EVA,' says Stewart. 'Why? Because they are being asked by the buy side to provide EVA research.'
So if the buy side is enthusiastic about investing based on economic valuation calculations, why haven't more companies got on the bandwagon? While it makes less sense for dot-com start-ups, economic metrics can apply to almost any company, particularly turnarounds and those emerging from the yoke of regulation. Yet, fewer than 1 percent of US public companies implement some form of EVA in their decision-making and compensation practices, according to one informed estimate. Of course, companies with a team of overpaid and underperforming managers are unlikely to be too keen.
Another reason some corporations may not be taking it up is that 'if they are talking exclusively to the sell side, they may not appreciate how important this is to the buy side,' suggests Holt's McConnell. 'Sell side analysts are rewarded for getting earnings estimates right. The buy side is more interested in getting the price right. Corporate managers must understand how the earnings conversation they had with the sell side will translate into valuation estimates by the buy side. And it is the buy side that is critical to determining stock price.'
Also key is using the same valuation language. One company that has recently begun managing itself in a CFROI framework is Maytag Corporation. 'We work with both the buy and sell side and saw this as a tool that others use to evaluate companies,' says Tom Schwartz, vice president and chief administrative officer at Maytag. 'We asked ourselves if there was some perspective portfolio managers gain from using CFROI which would help us understand how they look at us. It hasn't greatly affected our decision-making process as much as confirmed what we think should be our core strategies anyway.'
Open source
One indicator of how powerful EVA remains – and a likely springboard to further growth – can be found in the recent joint venture between Standard & Poor's and Stern Stewart to offer EVA and related performance metrics in a database called EVAntageTM. A companion to S&P's Research Insight product and drawing numbers from the Compustat database, it can help users calculate the economic profit of 1,300 large-cap North American companies.
'While many acknowledge the merits of EVA, one of the investment community's frustrations has been the lack of an easily accessible, standardized database they could look to as an alternative to conventional accounting metrics,' says Stewart. 'This is an enormous change that will really facilitate analysis in the financial community.'
Another big change involves the shift from a proprietary mindset to a more modern orientation where information is readily available. A major attraction is that EVAntage is almost infinitely customizable. 'Money managers who use the product can do what if? analysis,' says Geoff Hawksworth, vice president of Institutional Market Services at S&P. 'Users can point and click and pull down a sophisticated analysis, or they can deconstruct it and get beneath the skin of these formulas to see what the key drivers are. It is no longer a black box.'
Stern Stewart is also leveraging technology in other ways in order to speed dissemination of the EVA gospel. On June 6, it sent some 32,000 copies of an 'EVA Tutor' on CD-ROM to companies, investors and analysts. 'We are only a 200-person firm and when a large company asked for 10,000 people trained in EVA we blanched,' admits Stewart. '[The tutor] will provide a huge opportunity to leverage EVA to the rank and file across companies.'
For its part, Holt is also working to build a wider universe of relationships. On June 12 it announced a partnership with The Financial Relations Board /BSMG Worldwide to 'help corporations better integrate their investor relations with corporate strategies designed to create shareholder value'. FRB/BSMG will use Holt's CFROI valuation framework in its strategic IR practice.
'We had clients wondering why they had eight quarters of EPS growth yet their stock price was dropping,' explains Neal Cannon, vice president and manager of strategic positioning and valuation at FRB/BSMG Worldwide. 'Neither EPS nor P/E was explaining stock prices. CFROI does the best job at it.'
Whether the cult of economic metrics will one day totally replace that of EPS and other accounting yardsticks remains to be seen. It is clear, however, that EVA, CFROI and the rest of the alphabet soup of economic elixirs are increasingly taught in business and finance schools. As the old generation rolls over, it looks like valuation metrics will be driven up the organization. Until the next buzzword comes along, it remains the height of (understated) fashion. 'Valuedelic, baby.'