Journal of Applied Corporate Finance W I N T E R 1 9 9 7 V O L U M E 9 . 4

The Stern Stewart Performance 1000 by Irwin Ross

115JOURNAL OF APPLIED CORPORATE FINANCE

THE 1996 STERN STEWARTPERFORMANCE 1000

by Irwin Ross

115BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

nies in the year ending December 31, 1995 were thesame ones, with a single exception, that constitutedthe top ten the previous year, as determined by therankings of Market Value Added (MVA), the mostuseful indicator of corporate success in enrichingshareholders.

The Coca-Cola Co. remained in first place withits MVA now hitting $87.8 billion. And once again,the General Electric Co. came in second, with anMVA of $80.8 billion. Merck & Co., racking up $63.4billion in MVA, edged up to the third from the fifthposition. Philip Morris landed in the fifth spot, upfrom the seventh. The only newcomer among the topten was Exxon, which made the leap into the ninthspot from the thirteenth the year before. Motorolatumbled from number ten to number 31.

Why rank companies by Market Value Added?Because MVA is the best measure of a corporation’srecord in generating wealth—or squandering it.Simply put, MVA is the market value of a companyless the money invested in it; the excess representsthe stockholders’ true gain. MVA is computed by firstadding together the market value of the company’sdebt and equity and then subtracting the total fundsinvested in the company since day one, includingretained earnings.

MVA is a far more revealing figure than a simplerise in total market capitalization (a measure of sizerather than success), because the latter fails to

he most striking fact in the newestrankings of the Stern Stewart Perfor-mance 1000 is the consistent showing ofthe corporate stars. The top ten compa-

consider the money investors put up. For example,if a company increased market capitalization by $500million over five years, but at the same time plowedback $600 million in retained earnings, it actually haddestroyed $100 million of shareholder wealth.

The latest MVA numbers show an enormousamount of wealth creation over the last five years. Forthe top ten wealth creating industries, MVA in-creased by $84 billion. The No. 1 industry group-ing—drugs and research—increased its MVA by$12.7 billion, closely followed by computers, soft-ware, and services at $12.6 billion. Also notable wasthat 886 corporations on the newest list have positiveMVA with 114 coming up with negative MVA—abetter record than the prior year, when 148 compa-nies bore the onus of being wealth destroyers.

The bottom of the list has its own fascination andtells a lot about the hurdles confronting some failedindustrial Goliath’s that are capital-intensive and havefor years absorbed endless billions of investment. Thedistinction of being last on the list goes to the FordMotor Company, which had a negative MVA of $12.9billion. General Motors fared little better at number 998,with MVA of minus $8.2 billion. Chrysler did far betterwith a positive MVA of $2.2 billion. That was nosurprise, but Ford’s record was a chastening reminderthat despite the company’s good press and a forward-looking management, stockholders were still losingheavily. However, there had been progress—bothFord and GM showed less negative MVA than the yearbefore. So did IBM, No. 997, which is likely to shoot upin the next ranking because of its stellar stock marketperformance in 1996.

T

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Over the long haul, MVA is greatly influencedby a company’s EVA performance. Economic ValueAdded, a concept refined and popularized by SternStewart & Co., is a measure of true economic profit.Simply put, it is the profit realized after deducting thecost of all capital employed. More formally, EVA isdefined as net operating profit after-tax (NOPAT)less the weighted average cost of capital. EVA, inshort, encapsulates a truism about the nature ofprofit. As Roberto Goizuetta, Coca-Cola’s CEO, oncetold Fortune about EVA in what has become afamous line: “You only get richer if you invest moneyat a higher return than the cost of that money to you.Everybody knows that—but many seem to forget it.”

The corporations at the top of the MVA list havenot forgotten it. If you run you examine the accom-panying tables, you’ll find that most companies withhefty MVAs have enjoyed substantial boosts in EVA.Studies have shown that no financial measure corre-lates better with MVA growth than does EVA. But thetwo do not correlate perfectly because, while EVAmeasures current performance, share prices reflectexpectations; good current EVA numbers must holdforth the promise of future EVA improvement for themarket to react favorably.

The link between EVA and shareholder wealthhas led many leading corporations to formally adoptthe EVA discipline. Apart from Coca-Cola, theyinclude AT&T, Briggs & Stratton, Boise Cascade, EliLilly, Monsanto, and literally hundreds of others.Influenced by their example, during the last coupleof years several companies in the most diverse fields,including major recruits from Mexico, Brazil, andEurope, enlisted under the EVA banner. The grow-ing popularity of EVA has also been reflected on WallStreet, where an increasing number of analysts areusing EVA to pick winners and losers.

The Case of SPX

Many companies adopt EVA because they facedaunting problems that have resisted more conven-tional solutions. Charles Bowman, director of finan-cial planning and analysis at the Michigan-based SPXCorporation, a large manufacturer of specialty toolsand parts for the auto industry, is eloquent about thereasons his company enrolled: “We had a financialmanagement and planning system that was unclear,complicated, disjointed—we needed to reform it.We had an incentive compensation system that hadbeen frequently modified, which was hurting its

credibility—our people referred to it as the ‘flavor ofthe month.’ And we had some internal frustrationbetween financial objectives versus accounting ob-jectives. So that’s really what led up to it.”

To top it all off, Bowman added, “We had madea series of bad investment decisions.” He was notquarreling with the “strategy” involved, “but youhave to pay the right price for any strategy to pay off.”In the absence of an EVA calculation based on thecost of capital, overspending on acquisitions caneasily result from enthusiasm and the spur of com-petition, as at an auction.

SPX signed on to EVA in mid-1995 and spent sixmonths, with the help of Stern Stewart, devising anew system of financial management and reportingand an EVA-based bonus system, as well as a trainingprogram to indoctrinate the troops. “It takes at leastsix months to design an EVA management system,”says Bowman, “You can’t just call Joel Stern and say,‘Hey, we want to go on EVA! It takes time to designa system that will change your culture’.”

Bowman regards the new incentive plan ascrucial to the success of the enterprise because it onlypays off if the company’s EVA goal for the year isachieved. It is easy to keep track of progress orbacksliding because each division—which has an“expected improvement” factor that must be met—gets monthly reports of its EVA performance. The top180 people in the company went on the newincentive plan January 1, 1996, another 800 followedon July 1, and, according to Bowman, almost every-one will have been on EVA incentives since Januaryof this year.

Behavior has been significantly altered by thenew concentration on the cost of capital in everyphase of the company’s work. Soon after the planwent into effect on January 1, 1996, Bowman reports,we had “a lot of asset sales, warehouses we suddenlydidn’t need.” Almost overnight, managers becameaware of how much money could be tied up ininventory. “We hit the first quarter and for the firsttime in history our inventory went down.” So didoverall capital expenditures, with an initial cut of $50million in the first quarter, without the reductionbeing mandated by headquarters. Managers justdecided that they could safely do with less, whilesustaining growth.

During the course of the year, EVA analysis ledSPX to make a major divestiture—the sale of itspiston ring business to Dana Corporation for $225million. SPX had long been known for its piston

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rings, of which it was the largest U.S. manufacturer.But the business now required more investment toextend its global reach and to upgrade the productline. “We could have done it,” says Bowman, but “thequestion in the end was what’s the best way togenerate EVA improvement and we thought thatselling it, given the price we were getting, won outby a nose.” And it made eminent good sense forDana, he adds. “With the critical mass of the com-bined businesses,” says Bowman, “Dana will be wellpositioned to achieve global efficiencies.” The an-nouncement of the sale was made last August, but itsconsummation awaits regulatory approval.

Bowman stresses that economizing on inven-tories and capital expenditures, and downsizing ingeneral, will certainly improve short-term EVA per-formance, but can only take a company so far. Tomeet this demanding EI (expected improvement)figure, which is laid out for four years in advance, acompany must grow. All attention at SPX, he in-sists, is now focused on growth. It will be sometimebefore its latest EVA score is published (it didpoorly in 1995, as the tables indicate), but themarket has showed buoyant expectations. SPX’sshared traded at $10.875 in June 1995. In mid-January it traded at $41.

The Case of Allwaste

Allwaste Environmental Services, Inc., of Hous-ton embraced EVA as a solution to a naggingproblem that besets many companies. “We’ve beenconsistently profitable, but haven’t been able to yieldan adequate return that satisfies our shareholders,”says CFO Wayne Wren. As a result, Allwaste’s shareprice has lagged far behind the market for the lastseveral years. The company, which cleans every-thing from boilers to smokestacks and recycles allmanner of waste for large industrial companies, isthe only nationwide outfit in this noisome businessand has annual revenues of about $400 million. Itwas created in 1978 and grew largely by buying upma and pa-type operations until it constituted, asWren puts it, “a loose federation of independentcompanies reporting to a common parent” ratherthan 130 locations working together.

Local managers didn’t fully understand thatcapital has a cost. “We did not charge ourselves at in-the-field locations for capital,” Wren explains. “Ofcourse, at corporate we realized capital had a cost,but the concept that equity had a cost was a difficult

one for operating people.” Moreover, capital wasreadily available to the field simply by completingAFEs [authorizations for expenditure] that wereroutinely approved. Local managers were rated ontheir pre-tax earnings, but by employing morecapital they could in effect “buy earnings” even if novalue was created. “If you give me enough capital,and that capital is free,” says Wren, “I can assure youthat I’ll increase income.”

All of which raised capital costs and squeezedtrue profits. Their frustrations put senior manage-ment in a receptive mood when they attended a two-day Stern Stewart seminar in December 1995. “Wehad already started a program of trying to recognizethe costs of capital,” Wren recalls, “but we realizedat the seminar that we couldn’t do it ourselves.” LastMarch, Allwaste hired Stern Stewart to help devise aprogram. It took months and contained ingredientsfamiliar to the company. The periodic financialreports that are sent to location managers nowinclude the location’s NOPAT, cost of capital, and theresultant EVA figure, positive or negative.

And the incentive bonus plan, of course, is nowtied to EVA performance. Day One for the programwas September 1, but changes began to appear evenbefore the formal launching. Says an enthusiasticWren: “Our working capital has gone down, ouremphasis on collections has paid off.” The averagenumber of days outstanding declined, which meantthat less capital was tied up in unpaid billings. By thetime fiscal 1996 ended on August 31, capital expen-ditures for the year had declined 40% from what wasinitially planned.

Many fewer requests for capital are now com-ing from the field. Now when a local managerneeds a new truck or a hydroblaster, he taps intothe company’s e-mail system to discover what idleequipment is available at other locations. His bal-ance sheet picks up a capital charge when heborrows the item, but it is much less than the costof new equipment—and the transfer of coursecosts the company nothing. Meantime, analyst re-ports have taken favorable notice of the company’sadoption of EVA.

The Case of Herman Miller

Herman Miller Inc., the celebrated furnituremanufacturer headquartered in Zeeland, Michigan,also experienced favorable early results from theadoption of EVA. It had launched the program in the

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spring of 1995 after new management brought apainful awareness of its financial woes. As CFO BrianWalker candidly puts, “We had effectively lost ourway as to what it actually takes to create value. It wasas simple as that. We had operating expensesgrowing faster than sales. We were throwing allkinds of assets onto the balance sheet that were notproductive or we didn’t need. We really thoughtcapital was free and so the business was having aheart attack.”

Naturally, its stock price had fallen. Walkeradds: “Herman Miller was a billion dollar companywith a market cap of $500 million.” When it came tovaluation, the market was unimpressed by Miller’slustrous corporate image, its famous Eames loungechair or its enlightened employee relations.

Senior executives across the company did notgo on an EVA incentive plan until June 1, 1996, butfor months beforehand the new concepts had beenwidely discussed and had begun to change deci-sion-making. The most dramatic example, relatedby Walker, involved a metal-bending plant in Michi-gan. In the fall of 1995, its managers were pushingvery hard for an expansion of facilities; they fearedrunning out of capacity. But months later, whenWalker was ready to take the request to the board,he found that the plant managers had not sentalong a formal submission. They had changed theirminds and had instead adopted what they calledthe Toyota production system—realigning facilitiesso as to reduce the size of work cells, as well asreducing the amount of raw materials on hand tolittle more than a day’s needs, all of which cut thecapital tied up in inventory and provided morefloor space for production.

The drive to conserve capital has also led to thesale of some real estate, despite the company’s pridein its architecturally distinguished buildings. Thecompany sold off two manufacturing plants, inSanford, North Carolina and Irvine, California. It alsoput on the block an administration and light assem-bly building in western Michigan.

The current fiscal year marks Herman Miller’sbig EVA push, for the 125 executives now on EVAincentives will be followed by the bulk of thecompany’s 7,000 employees. Nonetheless, the changein attitudes has already been reflected in the company’soverall EVA results. In fiscal 1996, ending last May 31,Herman Miller produced $10,345,000 in EVA, asizable turnaround from the $13,391,000 in negativeEVA the prior year.

Vitro and Others

Other recent converts to EVA are reportingpromising results. Mexico’s Vitro, S.A., one of thegiants of the glass industry (flat glass, bottles, andmuch else) inaugurated EVA on January 1, 1996,enrolling its 500 top executives on an EVA-basedbonus plan. The company has five divisions, for eachof which EVA targets have been worked out; themanagers all regularly receive financial reports show-ing their EVA position. But during the first year EVAaccounting has been taken down to the business unitlevel in only one division, chemicals and packaging,where the task was easier because each business unitis a separate company. What changes have occurredso far? Jose Cantu, Vitro’s “organizational effective-ness manager,” replies, “I think we are in the middleof the change. People are asking, ‘What happens ifI take the decision based on EVA? What happens ifnot? How would my numbers come out if I make thisor that decision? EVA has become a very familiar termthroughout the organization’.” One concrete devel-opment, in which EVA analysis played a role, was thesale of the Anchor Glass subsidiary in Florida, whichhas been a headache for years.

Monsanto, the highly successful St. Louis-basedbio-agricultural and pharmaceutical company, be-came another recent convert to EVA in the beginningof 1996. The Stern Stewart consultants put two of thesmaller divisions of the company (Solaris and Protiva)on EVA in April. The other divisions, the bulk of thecompany, have not yet been affected. Monsanto isalso still formulating an EVA-based incentive plan.Early impressions at Protiva and Solaris are promis-ing, says Gregory Griffin, director of EVA. “Peopleare paying much more attention to inventory levels,they are paying much more attention to workingcapital like receivables, but it’s too early to tellwhether it’s changed people’s behavior completely.”

R. R. Donnelley & Sons, the far-flung printingcompany headquartered in Chicago, instituted EVAfor all 40 of its divisions on January 1, 1996, with theentire panoply of monthly reports, EVA improve-ment targets, and a fully delineated incentive planthat covers 1,000 executives. Jeff Miller, manager ofEVA, reports significant change in handling receiv-ables: “We’ve taken steps to look at terms that areoffered, we’ve looked at collection of receivables,we’ve instilled in our sales organizations that receiv-ables constitute an important asset of the company.”To inspire restraint on the part of salesmen who offer

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too generous terms, the company is studying theinclusion of a capital charge for receivables in salescompensation plans.

EVA calculations have also become central tothe company’s budgeting and capital allocationprocess for 1997. And EVA played a contributing rolein the company’s two divestitures in 1996—ofMetromail Corporation and Donnelley EnterpriseSolutions, units that were extraneous to its corebusiness. “We are also doing a better job of assetrationalization,” says Miller. “For instance, in the pastif we needed capacity in a certain area of thecompany, we would add it. Now we’re looking at theentire asset base and asking, ‘does it make sense toadd that capacity or does it make sense to shift it?’ Wehave a lot of work ahead of us. EVA is not somethingyou adopt and let go. You have to drive it con-stantly.”

EVA on Wall Street

During the past 20 months, EVA has also beengaining momentum on Wall Street. Analysts atbrokerage houses have for some time been reactingfavorably when a company adopts EVA, so it’s hardlysurprising that some analysts have taken to using thetechnique themselves. EVA analysis is of course aharder job for the outside analyst than for a corporatenumber cruncher, who is privy to all the necessarydata. The outside analyst has only the publisheddata, unless the company lifts the veil. For thecorporation as a whole, he can devise an EVAperformance figure by making the necessary ac-counting adjustments, computing after-tax operat-ing profits and estimating the corporation’s cost ofcapital. That cost, deducted from the after-tax oper-ating profit, will of course yield the EVA number.

But many analysts want to go further, comingup with the EVA performance of different parts of acompany. Without this knowledge, one cannot fullyjudge overall management and corporate strategy. AlJackson, the head of global equity research at CS FirstBoston, is proud of his analysts’ ability to detect whathe calls “cross subsidization”—the tendency in manylarge organizations for the prosperous parts of acompany to support their poor sisters, often to thedetriment of the company as a whole. But to makethis analysis, one needs not only line-of-businessP&L reporting by the company, but also a similarbalance sheet breakdown in order to determine capitalallocation between divisions and thus relative EVAs.

How to find out? “You ask the companies,”says Jackson. “You don’t just ask the question flatout, of course. You research the matter, throughsuppliers and other industry contacts. You work upa model based on what you have learned. Then youtalk to the corporate finance people.” ContinuesJackson: “You’ll provide rough estimates of how thecapital is allocated and the company will tell youthat you are too far off or pretty close—or give yousome guidance that will get you closer to the realanswer.” All 48 of Jackson’s analysts work thesystem and their record is good. For the first three-quarters of last year, First Boston led the majorbrokerage houses in the performance rankings oftheir stock recommendations.

David Beard was trained in Jackson’s shop andfor the last two years he and Charles H.C. Honey havebeen applying the same concepts at Trainer, Wortham& Co., where they run a small mutual fund ($30million) and another $50 million in institutionalmoney. Their record has been good, far outperform-ing the Dow and S&P 5000.

They have worked out a valuation model, inwhich the EVA calculation is the crucial ingredient,that they apply to 100 companies each year, exercis-ing their insight and charm to pry capital allocationfigures from companies in the fashion Jacksonsuggests. They point out that their estimates do nothave to be as precise as those of a company runningits own EVA program, where incentive bonuseshinge on the fine-tuning of the figures. It is enoughfor them to get the relative proportions right—andthe direction of movement—in order to make goodstock picks.

At Oppenheimer Capital, which manages some$40 billion in assets, Eugene Vessel and his analystshave for years been applying the concepts of EVA,if not its precise methodology, to companies inwhich it takes large positions. Vessel notes that hispath to EVA has followed a natural progression.“My training has always been return on invest-ment,” he says, “not earnings per share.” EVAmakes explicit the cost of equity, he explains,which was always implicitly involved in any calcu-lation of a proper return on investment. “The otherthing that EVA does is that it takes you fromaccounting to cash. Cash is reality, accounting is itsown screwy world. It is clear that companies thathave a better cash-on-cash return do better on thestock.” The key thing that Vessel looks for is howwell companies allocate capital. “By allocating well

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I mean using capital only when you have a returnabove the cost of capital.”

Charles Sheedy, a senior vice president of theFayez Serofim money management firm in Hous-ton, developed an interest in EVA because of hislong orientation towards cash flow per share whenmost analysts were obsessed with per-share earn-ings. For the oil industry, in which Sheedy’s firmwas heavily invested in the late 1970s and the early1980s, cash flow was the crucial measure. Then,during the last half dozen years, Sheedy observedthat many of the best performers among the corpo-rations in his portfolio—led by Coca-Cola—reliedheavily on EVA. His interest in the subject grew,

and last spring he hosted a one-day EVA seminar athis firm. All 12 of the firm’s analysts are nowproficient in the technique.

Look anywhere on the Street these days, andyou’ll find growing interest in EVA. Goldman, Sachs,one of Wall Street’s most prestigious firms, is aboutto launch an EVA training program for its army ofanalysts. Stern Stewart also is training analysts atBanque Paribas and Robert Sherwood in Europe,and has worked with analysts at other firms todevelop special valuation for specific industries. “Isall this activity an analytical fad?” muses Vessel.“Hardly. EVA appeals to analysts because it’s thecodification of common sense.”

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