Journal of Applied Corporate Finance W I N T E R 1 9 9 4 V O L U M E 6 . 4

The Stern Stewart Performance 1000: Using EVA™ To Build Market Value by Laura Walbert

VOLUME 6 NUMBER 4 WINTER 1994109109

CONTINENTAL BANK JOURNAL OF APPLIED CORPORATE FINANCE

THE STERN STEWARTPERFORMANCE 1000:USING EVA™ TO BUILDMARKET VALUE

by Laura Walbert

be feeling a sense of that time these days, and hap-

pily so. What’s old is the fundamental financial theory

of economic or “residual” profits. What’s new is the

New York advisory firm’s application of the theory.

Called “economic value added” or EVA, the Stern

Stewart framework focuses managers on creating

wealth for shareholders. EVA has garnered wide-

spread attention lately. A September 20, 1993, article

in Fortune magazine called EVA “the real key to

creating wealth.”

The theory of economic profits says that the

value of a business is determined by its ability to

generate returns in excess of its cost of capital and

the amount of such investment. If a company can’t

earn so-called economic profits, then the capital

markets will reduce the flow of assets to that com-

pany. Conversely, capital will flow readily to busi-

nesses that can generate economic profits.

here’s a song that talks about a time

“when everything old is new again.”

Joel Stern and Bennett Stewart might

T

110JOURNAL OF APPLIED CORPORATE FINANCE

Stern Stewart’s calculation of economic profits,EVA™, subtracts a company’s cost of capital (debtand equity) from its net operating profits after tax. Apositive EVA indicates that a company is generatingeconomic profits; a negative EVA indicates that it isnot.

While EVA is the internal measure that operatingmanagers can employ as the driver of their businessdecisions, “MVA” or “Market Value Added” providesthe stock market’s assessment of management’sefficiency in using capital. The MVA performance,measured each year by the Stern Stewart Perfor-mance 1000 ranking, indicates the wealth a com-pany has created for shareholders. MVA is calculatedas the difference between a company’s total marketvalue and the total capital (both debt and equity)contributed by all investors over time to generate thatvalue. A company with a positive MVA is buildingvalue for its shareholders; a company with a negativeMVA is destroying shareholder value.

Again, the idea behind MVA may not be so new,but it’s an invaluable one. As far back as 1984, notedinvestor Warren Buffett was writing in his BerkshireHathaway annual report, “We feel noble intentionsshould be checked periodically against results. Wetest the wisdom of retaining earnings by assessingwhether retention, over time, delivers shareholdersat least $1 of market value for each $1 retained.”Buffett, it would appear, was calculating MVA.Michael Jensen, a professor at the Harvard BusinessSchool, says simply, “It’s about time that somebodystarted to focus attention on real results rather thanjust size.”

The 1993 Stern Stewart Performance 1000, aranking of U.S. industrial and non-financial servicecompanies on the basis of market value added as ofyear-end 1992, does just that. Companies such asGeneral Motors and IBM that top rankings of sheersize fall to the bottom of the pack when measuredon the basis of performance for shareholders. Gen-eral Motors earns the No. 999 slot, with an MVA ofnegative $15.9 billion, meaning that General Motors’market value is $15.9 billion less than the amount ofits total invested capital. IBM earns the No. 1000 slot,with a negative MVA of $23.7 billion, along with thedubious distinction of having the largest decline inMVA over the past five years. Between 1987 and1992, IBM slid from the No. 2 position to dead last,while its MVA declined by $41.5 billion.

Sitting in the No. 1 position again this year isWal-Mart Stores, with an MVA of $64.1 billion. Says

Stewart, “Without selling addictive products, withouthaving brilliant scientific minds, without having alongstanding consumer franchise to capitalize upon,Wal-Mart is the most value-creating business inAmerica, and they do it in retailing, a maturebusiness!”

Stern Stewart’s calculations are designed toavoid some of the more problematic practices ofconventional accounting. In figuring the compo-nents of MVA and EVA, Stern Stewart calculates aneconomic book value for each company that istypically higher than the company’s ordinary bookvalue. That’s because such items as bad debt reservesand deferred income taxes are added back in. Thecalculation also capitalizes research and develop-ment spending, amortizing the costs over five years.In fact, research from the Stern Stewart Performance1000 shows that EVA is the performance measuremost closely linked to MVA—more so than EPS,ROE, cash flow, or any other accounting-basedmeasure.

The MVA ranking provides an ideal base fromwhich to discern trends and make comparisonsamong companies and industries. You can spotstandout performers. At the bottom of the list, forinstance, are computer hardware manufacturers,like IBM and Digital Equipment Corp. (No. 997), andautomakers, like General Motors and Ford (No. 998).Yet Hewlett-Packard bucks the decline among hard-ware manufacturers, taking the No. 45 slot. AndChrysler’s successful turnaround is reflected in theclimb back to No. 405 from No. 996 last year.

General Electric and Westinghouse have simi-larities as electrical products companies that havewidely diversified. But there’s not much similarabout their performance, or their approaches tomanagement and diversification. GE has been on thevanguard of decentralization. By pushing account-ability down to business units, the most knowledge-able people are making key decisions, resulting in asuccessful acquisition campaign. Alternatively, whilemaintaining an obsolete organizational structure ofcommand and control from on-high, Westinghousehas neglected its basic businesses, and made un-timely investments in real estate and financial ser-vices. The result: General Electric has been a topMVA performer, taking the No. 4 slot this year, whileWestinghouse has slumped to No. 987.

Look also at the industry groups. Among the top50 MVA companies, 60% are in brand-name con-sumer products, pharmaceuticals, and telecommu-

VOLUME 6 NUMBER 4 WINTER 1994111

nications. That’s interesting, but not surprising giventhe health of those industries. But would you expect10% of the top 50 companies to be in distribution?Wal-Mart, Home Depot, Toys R Us, The Limited, andMcDonald’s all rank in the top 50 and fall into thatcategory of mass distribution. Says Stewart, “Mostpeople would look at the distribution business asintrinsically unappealing because it is mature andoperates with paper-thin margins. But these compa-nies have a low ratio of capital to sales. They tend toturn their capital many, many times.”

Being in a capital-intensive industry does notprevent companies from climbing up the MVArankings, however. Telecommunications qualifiesas one of the most capital-intensive businesses. In1992, companies like McCaw Cellular, Century Com-munications, Liberty Media, LIN Broadcasting, andContel Cellular all have capital-to-sales ratios nearing500% or higher. Yet the five companies each alsoboast a healthy, positive MVA. And regional tele-phone operating companies, such as SouthwesternBell (No. 34), Bell Atlantic (No. 37), AmericanInformation Technologies (No. 42), Bell South (No.43), and Pacific Telesis (No. 51) are top-runners inthe MVA ranking.

But while capital comparisons across industriesare not particularly relevant, capital comparisonswithin an industry are very telling. Says Stewart,“Within industries, if a company has less capitalemployed, it can reflect relative efficiencies.” Amongcomputer hardware manufacturers, Hewlett-Packard’scapital-to-sales ratio is 80.3%. DEC’s capital ratio is90.2%, and IBM’s capital-to-sales ratio is 116.7%. RayCookingham, controller at Hewlett-Packard, saysmanagers there are forced to consider capital. Hesays, “We have quite a decentralized decision-making environment. We try to reinforce ownershipof employed assets down at the product line level.”

Capital efficiency is the message the SternStewart approach hammers home. Emerson Electric(No. 35), which adopted the EVA™ system twentyyears ago, is widely regarded as a company withconsistently strong performance. Says Charles Pe-ters, Emerson’s vice president of development andtechnology, “It’s a very simple measure and it steerspeople to look at investment on an incrementalbasis. You can use the measure at any level and lookat 50 different plans within our company and makesome judgment about their value.”

At Emerson Electric, scrutinizing capital expen-ditures does not mean avoiding them, however.

Over the past decade, Emerson has made acquisi-tions totalling $4.5 billion in revenues. Also, Emersontoday spends 3.5% of its $8 billion in revenues onengineering and development, up from 2.9% adecade ago. “You would think that with this disci-pline, you would reduce every cost category. In fact,we have increased engineering and development asa percent of sales every year,” says Peters. Thatincreased investment has generated something of anew product boom at Emerson. Says Peters, “Weused to have 50 new products come out each year.Now we’re suddenly looking at 85 or 90 newproducts each year.”

Top-ranked Wal-Mart has a well-known repu-tation for controlling costs. Yet Wal-Mart doesn’tscrimp when it comes to capital investment. In thepast six years, Wal-Mart has spent more than $600million in information technology. And every Wal-Mart store that reaches its seventh year gets a facelift.Wal-Mart CEO David Glass says, “Even if the store isnot setting the world on fire, we’ll bring it to currentstandards.” Glass adds emphatically, “The worstthing you can do is sit with your stores, veryprofitable stores but inadequate facilities, and be-lieve your customers will continue to facilitate you.They will not.”

Glass attends closely to return on capital be-fore making major expansions in Wal-Mart’s busi-ness. Says Glass of the Sam’s Clubs wholesalegroup, “We started working on the wholesale clubsin 1982. We put in three of them, experimentedwith them, fine-tuned them, operated them, untilwe were able to get the return in Sam’s up to whatit was at Wal-Mart. Then we rolled the wholesaleclubs out.” Likewise, Glass tinkered with theSupercenter format for five years to achieve thenecessary returns. In 1993, Wal-Mart rolled out 45Supercenters, bringing the total to 75.

Scott Paper, No. 768 as of year-end 1992, is arecent EVA convert. The company began to imple-ment EVA this year in an effort to find a better wayto manage. Says CFO Basil Anderson, “We used tohave different financial measures for different pur-poses—discounted cash flow for capital decisions,another measure for rewarding performance and thelike.” The trouble was, two different managementsystems could lead to two different conclusions. SaysAnderson, “There was no direct connection betweenhow I evaluated current performance and how Ievaluated a project decision. Now EVA is onemeasure that integrates all that.” He adds that EVA

112JOURNAL OF APPLIED CORPORATE FINANCE

“provides the total picture rather than just part of thepicture. And, it offers an excellent link to the creationof shareholder value.”

The company that made the biggest one-yeardash up the MVA list in 1992 underwent a majorcapital restructuring. Compaq Computer Corp. roseto No. 223 from No. 922, with its MVA climbing fromnegative $284 million to positive $3.9 billion. CreditCompaq’s new CEO, Eckhard Pfeiffer, says JohnMaxwell, an analyst with SoundView Financial Groupin Stamford, CT. Maxwell says, “Pfeiffer cut theoverhead and staff way down, and was able to reducethe cost of business about 63% in his first year.”

Compaq, traditionally a first-to-market, pre-mium-priced computer maker, had stumbled whenit failed to meet industry price cutting. Then Compaqtransformed itself. Says Maxwell, “You had the PCclone manufacturers in there brandishing their stickof fire, and Compaq came around and said, ‘We’regoing to switch from using our income statement tousing our balance sheet.’” Daryl White, CompaqCFO, says of the restructuring, “Today we areproducing four times the number of units with netproperty, plant and equipment that’s $150 millionless. We have fewer people today than in 1991 byabout 15% or 20% and we’re producing double therevenue. We have revenue per employee of around$700,000, by my calculation, the highest in theindustry. I can’t think of any company that’s above$500,000 per person today.” Bennett Stewart agrees,“Having a premium brand is no longer enough. Thebrand must be built and maintained efficiently,thereby delivering more value for both the compa-nies and their customers. Meanwhile, Compaq hasserved up an impressive plate of new consumer-oriented products, with 250 products introductionssince 1991.”

Chrysler’s revamping has been equally dra-matic. The company’s negative EVA™ was cut bytwo-thirds in the past year, and its MVA swung fromnegative $3.7 billion to positive $559 million. ChryslerCFO Gary Valade credits the turnaround, in part, tocontinued product spending through a cyclical down-turn. He says, “In this last downturn, we did some-thing differently. We protected the product program

at almost all costs, while we went after every otherelement of cost. Before we would have delayedproduct or cut budgets across the board.”

Chrysler also reworked its accounting system toallocate overhead directly to processes rather thandepartments. Says Valade, “Then you can start tolook at processes and the time it takes to do thingsand waste in the system, rather than just trying to cuta line of the budget by 10%.”

Another company that has made the long climbup the MVA ranking is AT&T. In 1987, AT&T rankedonly No. 953. Today, after a restructuring that droveaccountability down to individual business units,AT&T stands at No. 7. Says Jim Meenan, CFO ofAT&T’s communications services group, “We hadrun the business on an income statement basis. Overthe past three years we’ve been working to getbalance sheets and cashflow statements out tosmaller, discreet business units to drive the entrepre-neurial spirit as if they had to go to their banker everymonth to get cash.”

That strategy has led to the kind of little changesthat add up. For instance, Meenan says, in thenetwork business, many central switching officeswere carrying their own spare circuit packs. Nowinventory of spare packs is aggregated at a higherlevel, reducing inventory. Taxes are being addressedat the unit level, rather than just at corporate. Meenansays, “Every decision is now based on EVA. Themotivation of our business units is no longer just tomake a profit. The drive is to earn the cost of capital.”And the folks at AT&T look on that as drivingshareholder value. Meenan adds, “The correlationbetween MVA and EVA is very high. So when youdrive your business units toward EVA, you’re reallydriving the correlation with market value,” or MVA.

Joel Stern adds, “Integrating an EVA incentivesystem with performance measurement fully alignsmanagement and shareholder interests. EVA incen-tives, in place at firms like Scott and Quaker, drivemanagement to develop value-maximizing businessplans.” And, as Quaker Oats’ CEO William Smithburgnotes in Fortune’s September 20 article, “EVA makesmanagers act like shareholders. It’s the true corpo-rate faith for the 1990s.”

EVA is a trademark of Stern Stewart & Co.

Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN 1745-6622 [online]) is published quarterly on behalf of Morgan Stanley by Blackwell Publishing, with offices at 350 Main Street, Malden, MA 02148, USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: +44 1865 471775, or e-mail: subscrip@bos.blackwellpublishing.com.

Information For Subscribers For new orders, renewals, sample copy re-quests, claims, changes of address, and all other subscription correspon-dence, please contact the Customer Service Department at your nearest Blackwell office.

Subscription Rates for Volume 17 (four issues) Institutional Premium Rate* The Americas† $330, Rest of World £201; Commercial Company Pre-mium Rate, The Americas $440, Rest of World £268; Individual Rate, The Americas $95, Rest of World £70, Ð105‡; Students**, The Americas $50, Rest of World £28, Ð42.

*Includes print plus premium online access to the current and all available backfiles. Print and online-only rates are also available (see below).

†Customers in Canada should add 7% GST or provide evidence of entitlement to exemption ‡Customers in the UK should add VAT at 5%; customers in the EU should also add VAT at 5%, or provide a VAT registration number or evidence of entitle-ment to exemption

** Students must present a copy of their student ID card to receive this rate.

For more information about Blackwell Publishing journals, including online ac-cess information, terms and conditions, and other pricing options, please visit www.blackwellpublishing.com or contact our customer service department, tel: (800) 835-6770 or +44 1865 778315 (UK office).

Back Issues Back issues are available from the publisher at the current single- issue rate.

Mailing Journal of Applied Corporate Finance is mailed Standard Rate. Mail-ing to rest of world by DHL Smart & Global Mail. Canadian mail is sent by Canadian publications mail agreement number 40573520. Postmaster Send all address changes to Journal of Applied Corporate Finance, Blackwell Publishing Inc., Journals Subscription Department, 350 Main St., Malden, MA 02148-5020.

Journal of Applied Corporate Finance is available online through Synergy, Blackwell’s online journal service which allows you to:• Browse tables of contents and abstracts from over 290 professional,

science, social science, and medical journals• Create your own Personal Homepage from which you can access your

personal subscriptions, set up e-mail table of contents alerts and run saved searches

• Perform detailed searches across our database of titles and save the search criteria for future use

• Link to and from bibliographic databases such as ISI.Sign up for free today at http://www.blackwell-synergy.com.

Disclaimer The Publisher, Morgan Stanley, its affiliates, and the Editor cannot be held responsible for errors or any consequences arising from the use of information contained in this journal. The views and opinions expressed in this journal do not necessarily represent those of the Publisher, Morgan Stanley, its affiliates, and Editor, neither does the publication of advertisements con-stitute any endorsement by the Publisher, Morgan Stanley, its affiliates, and Editor of the products advertised. No person should purchase or sell any security or asset in reliance on any information in this journal.

Morgan Stanley is a full service financial services company active in the securi-ties, investment management and credit services businesses. Morgan Stanley may have and may seek to have business relationships with any person or company named in this journal.

Copyright © 2004 Morgan Stanley. All rights reserved. No part of this publi-cation may be reproduced, stored or transmitted in whole or part in any form or by any means without the prior permission in writing from the copyright holder. Authorization to photocopy items for internal or personal use or for the internal or personal use of specific clients is granted by the copyright holder for libraries and other users of the Copyright Clearance Center (CCC), 222 Rosewood Drive, Danvers, MA 01923, USA (www.copyright.com), provided the appropriate fee is paid directly to the CCC. This consent does not extend to other kinds of copying, such as copying for general distribution for advertis-ing or promotional purposes, for creating new collective works or for resale. Institutions with a paid subscription to this journal may make photocopies for teaching purposes and academic course-packs free of charge provided such copies are not resold. For all other permissions inquiries, including requests to republish material in another work, please contact the Journals Rights and Permissions Coordinator, Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ. E-mail: journalsrights@oxon.blackwellpublishing.com.