Cover Story: How EVA Exposes Non-performers

Is the destruction of company’s ‘real’ market value an indicator of management competence? If it is, then the boards of directors of some of our largest companies should be taking long hard look at the performance of their top executives. In some cases, such as Air New Zealand, they have already. Further down the hierarchy of our Top 200 companies, the news is not so bleak. There are some good performing companies and, by association, some top performing managers. What can help directors more accurately assess the ‘true’ competence and worth of their well-paid CEOs? It’s called EVA – economic value add – the management and organisational performance indicator that too many major enterprises ignore.

When it comes to creating wealth for the companies that employ them, our top managers are not top performers, according to the results of international management consultant Stern Stewart’s 2001 Wealth Creators Analysis. Kiwi companies fare badly overall when compared with their international counterparts. But the researcher admits that few bad apples, namely Telecom, Air New Zealand, Carter Holt Harvey and Fletcher Challenge Forests (the country’s big wealth destroyers last year) dragged down what is otherwise generally good bill of health for Kiwi businesses.

Last year the managers of the top 35 companies listed on the New Zealand Stock Exchange (NZSE), destroyed 10 percent of their market value added (MVA). The companies represent 90 percent of the $44.3 billion market capitalisation of the nation’s 130 fully listed enterprises.

MVA is measure of the value managers add to the capital employed in business. By contrast, the top 150 companies in Australia, also representing 90 percent of the Australian Stock Exchange (ASX), increased their MVA by four percent. Similarly, last year the NZSE’s top 35 had an MVA-to-capital ratio of just 31 percent compared with the ASX top 150’s 78 percent.

But drill down into the heartland of corporate New Zealand (where 80 percent of Kiwi companies reside) and it’s different story. For the most part, the middle 80 percent is doing well and holding its own in sync with offshore counterparts.

Surprisingly, Stern Stewart’s latest analysis shows that New Zealand’s medium-sized listed companies out-perform their Australian cousins. New Zealand companies improved their MVA (or shareholder value creation) by 25 percent, slightly better than their Australian counterparts, who achieved 24 percent increase. Equally important, New Zealand’s middle-of-the-table companies had an impressive MVA-to-capital ratio of 71 percent, compared with the 58 percent achieved by their Aussie equivalents.

EVA double-speak
Martin Concannon, until last month managing director Australia/New Zealand with Stern Stewart, says Kiwi managers should ask themselves two key questions: How do we find the incremental compound growth that isn’t being picked up? And, what’s holding us back from maximising value creation?

Stern Stewart’s last wealth creation rankings show that EVA-driven companies every year outperform their peers by around eight percentage points. What EVA does, says Concannon, who has returned to Sterm Stewart’s New York office, is provide better measure of how companies are performing by measuring the extent to which profits exceed the cost of capital.

Ironically, Kiwi companies lead the world in talking about EVA in financial statements. Sadly, management doesn’t walk the talk and so when it comes to doing it, New Zealand is back in the dark ages, according to Concannon.

He argues that if 600 private and public companies can destroy in excess of $3.3 billion in capital (3.3% of GDP) – then simply being able to foot-it with offshore counterparts isn’t good enough. With only one in four companies analysed qualifying as true wealth creators there’s lot of work to be done.

Outdated dividend policies
Concannon believes New Zealand’s outdated penchant for giving far too much money back to shareholders is at the core of what severely limits wealth creation in most Kiwi companies. “By returning so much in earnings to shareholders as dividends, companies are playing to market that doesn’t exist any more. It’s also puzzling why so many Kiwi firms will issue dividend in one breath only to ask for it back in the next.”

The focus on dividends requires fundamental rethink, says Joseph Healy, head of regional investment banking and private equity with ANZ Investment Bank (Australia). In many cases, he says, dividend policy is bringing about the liquidation of the business. “For businesses with little hope of growing value in the future, this is appropriate – for many other good businesses it is inappropriate.”

But do companies have the management capability needed to use that extra capital effectively? The short answer in too many cases, according to Comalco chief executive Kerry McDonald, is no. He identifies the major impediment to corporate productivity as serious lack of capable and effective management systems and processes. “What’s lacking is effective management infrastructures. Too few firms achieve their potential and too many fail. It comes down to lack of commitment to developing the tools, practices and processes that let good managers and leaders achieve the best results.”

Comprehensive measures of total performance are needed to highlight ineffective management, says Concannon. This year’s ranking shows convincingly that investors and corporate leaders should be looking at MVA and not just market value. That means focusing on what the company might sell for as opposed to the capital used to build it.

Many New Zealand businesses have created enormous wealth for shareholders. The Stern Stewart study showed that at June 30 last year, the country’s 35 largest publicly listed companies created $14 billion in wealth. But clearly many companies continue to struggle in the wealth generation stakes.

Abusing shareholder funds
The trouble, says Concannon is that while capital management has become more popular in recent years, many New Zealand businesses still treat shareholders’ funds as if they are free. “For boards of directors and CEOs, wealth creation is not merely function of profit or size. The level of capital invested is also critical, and so is the cost of that capital. Ignoring MVA can be dangerous for CEOs and boards. Studies show that falling MVA is one of the leading forward indicators of CEO dismissal.”

If companies governed by EVA principles have better insights into their overall performance, when should EVA be applied? That, according to Concannon, is like asking – when is it good time to come in out of the rain?

EVA may be hard concept for people further down the management chain to get their heads around, but in practice, the principles of EVA can and should be applied deep down in the company’s core operations.

Concannon believes executives should be held accountable for delivering EVA in the current period and they should be ensuring that strategies are in place to show incremental growth in future EVA. For example, by using accounting data in different fashion, store managers of large retail chain could identify what products require more capital relative to the returns they deliver. “Operational by nature, EVA helps managers understand the economic impacts of business processes and how they affect wealth creation.”

Out of 10 things recently implemented, managers might be able to identify more quickly those that aren’t adding value. The essence of EVA is to help management to analyse and justify the changes they make. Right or wrong, EVA explains the fuller impact of those changes on the business. “EVA is the most comprehensive measure of corporate performance because it accounts for underlying profits after all costs have been deducted – including the cost of shareholders’ funds,” he says.

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