The Real Key To Creating Wealth
Rewarded by knockout results, managers and investors are peering into the heart of what makes businesses valuable by using a tool called Economic Value Added. September 20, 1993 By Shawn Tully
WHAT IF you could look at almost any business operation and see immediately whether it was becoming more valuable or less? What if you as a manager could use this measure to make sure your operation—however large or small—was increasing in value? What if you as an investor could use it to spot stocks that were far likelier than most to rise high? What if using this measure would give you a marked competitive advantage, since most managers and investors aren't using it? There is such a measure—but you'll have to move fast to seize your competitive advantage, because it is catching on quick. It goes by several names, depending on which user or consulting firm you talk to; McKinsey and others do a lively trade teaching it. The preeminent popularizer of the concept is Stern Stewart & Co. of New York City, which calls it economic value added, or EVA. It is today's hottest financial idea and getting hotter. Seeing why is easy—just look at the charts on this page. Managers who run their businesses according to the precepts of EVA have hugely increased the value of their companies. Investors who know about EVA, and know which companies are employing it, have grown rich. Little wonder that highly regarded major corporations—Coca-Cola, AT&T, Quaker Oats, Briggs & Stratton, CSX, and many others—are flocking to the concept. ''EVA played a significant role'' in AT&T's recent decision to buy McCaw Cellular for $12.6 billion, says William H. Kurtz, an AT&T financial executive. AT&T this year will make EVA the primary measure of business units' and managers' performance. Explains Quaker CEO William Smithburg: ''EVA makes managers act like
shareholders. It's the true corporate faith for the 1990s.'' So what is it? Simply stated, EVA is just a way of measuring an operation's real profitability. What makes it so revealing is that it takes into account a factor no conventional measure includes: the total cost of the operation's capital. The capital is all the money tied up in such things as heavy equipment, real estate, computers, and other stuff that's expected to be productive for a while after it has been purchased, plus so-called working capital, mainly cash, inventories, and receivables. EVA is simply after-tax operating profit, a widely used measure, minus the total annual cost of capital. Here's how Coca-Cola CEO Roberto Goizueta, a champion wealth creator, explains it: ''We raise capital to make concentrate, and sell it at an operating profit. Then we pay the cost of that capital. Shareholders pocket the difference.'' This turns out to be profound. Incredibly, most corporate groups, divisions, and departments have no idea how much capital they tie up or what it costs. True, the cost of borrowed capital shows up in a company's interest expense. But the cost of equity capital, which the shareholders have contributed, typically appears nowhere in any financial statements—and equity is extraordinarily expensive capital. Until managers figure all this out, they can't know whether they're covering all their costs and adding value to a company. Understand that while EVA is easily today's leading idea in corporate finance and one of the most talked about in business, it is far from the newest. On the contrary: Earning more than the cost of capital is 1
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about the oldest idea in enterprise. But just as Greece's glories were forgotten in the Dark Ages, to be rediscovered in the Renaissance, so the idea behind EVA has often been lost in ever darker muddles of accounting. Managers and investors who come upon it act as if they have seen a revelation. You'd act that way too if you had been at...
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