Economic Value Added: A New Performance Measure for Incentive Pay
By: Keith Kefgen and Rosemary Mahoney October, 1996
In our previous discussion on incentive compensation, we identified traditional performance measures for linking pay and performance. They included measures of earnings per share, gross operation profit, cost containment and/or growth criteria, return on equity and so forth. There is a new performance measure receiving a great deal of attention and scrutiny: Economic Value Added (EVA). Simplified, EVA is a measurement tool that determines if a business is earning more than its true cost of capital. Proponents of EVA believe it gives managers a clearer idea of whether they are creating or destroying shareholder wealth.
To calculate your company or department EVA, you must first determine your cost of capital for both debt and equity. The cost of debt is simply the interest rate your banks and/or bondholders charge. What most managers forget is that equity also comes with a price tag. Just because there is no line item for equity on the P&L statement doesn’t mean it’s free. The real cost of equity is what your shareholders could be earning elsewhere.
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Table 1 |
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Company |
Weighted Cost of Capital Multiplied by: |
Total Capital $ Millions Equals |
Total Cost of Capital $ Millions |
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| Walt Disney |
12.3% |
$9,283 |
$1,141 |
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| Disney Numbers Represent Fiscal Year 1995 / Source: HVS Executive Search | ||||||
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Table 2 |
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| Company |
After Tax Net Operating Profit $ Millions Minus |
Total Cost of Capital $ Millions Equals |
EVA $ Millions |
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|
Walt Disney |
$1,660 |
$1,141 |
$519 |
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In today’s market, the approximate cost of equity is 12.5%, depending on industry risk factors. This represents the risk-free interest rate of 6.5%, plus an additional six percentage points for inducing the average investor to purchase your stock.
Once you have determined your weighted cost of capital, multiply it by your total capital to arrive at your total cost of capital. For example, Walt Disney’s total cost of capital is $1,141 million. (see table 1). When compared to Disney’s after-tax net operating profit of $1,660 million, an EVA of $519 million is the result (see table 2). If you have a positive EVA, Like Disney, you created real wealth, if not, you have burned shareholders.
Why should this measurement tool be used in determining incentive pay? Simple, it motivates managers to think like shareholders. We have found in our studies that when employees have a vested interest in the ownership of the business, performance always improves. Furthermore, rewards are more clearly based on the true performance of the business.
How is an EVA-based incentive plan implemented? Just like any other incentive plan. Our advice is to take your time when benchmarking EVA criteria, create formulas that are easy to comprehend and then train your employees like crazy to get company-wide acceptance. If you make these plans too complicated, employers won’t understand them, and thus the desired effect is lost. Done correctly, EVA can create a major cultural change in your company, aligning the fortunes of both management and ownership. Remember, nothing in business is free, so take care of your investors or at some point they will make you pay dearly.
HVS Executive Search is a Mineola, NY based human resources consulting firm. The firm is headed by Keith Kefgen, President, and Rosemary Mahoney, Director. HVS Executive Search provides retained executive search, compensation consulting, employee-opinion surveys and organization development.
For additonal information contact the firm at
HVS Executive Search
372 Willis Avenue
Mineola, NY 11501
Phone: 516-248-8828 Fax: 516-742-1905
or Email Mr. Kefgen at kxk@hvs-intl.com