Alpha Corporation

Developing Successful EVABased Incentives

Copyright December 11, 1997

Three Stages of EVA Implementation

Building EVA awareness Linking pay decisively to EVA Developing EVA-based action steps for line managers.

EVA is a registered trademark of Stern Stewart & Co. The directors of Finegan & Gressle are former partners and officers of Stern Stewart who contributed significantly to developing and popularizing EVA.

Measuring Corporate Success:

The Ultimate Financial Test

A large Market Rapid highstock stock and growing price price? market capitalization? appreciation? premium to book value? !

Cost of Invested Capital

Total Market Value

The MVA Scorecard

MVA Winners

MVA Losers ($77.1) (52.4) (46.4) (36.7) (34.0) (19.5) (14.4) (7.0) (6.4) (6.0)

Coca-Cola $124.1 ITT Microsoft 83.3 General Motors The Point: Coke and GM have identical trading values, Intel 85.0 Loews but GM invested $200 billion more than Total Market Value $134.5 Merck American Express Coke to 72.5 get there. Total Market Value $135.5 Capital Invested 10.4 Phillip Morris 59.8 Ford Motor Company During the last187.9 5 years alone, Coke Capital Invested MVA $124.1 Proctor & Gamble generated 54.5 Travelers Group $73 billion more in value than MVA ($52.4) Exxon 51.5 RJR Nabisco could have been expected from the market 5-Year XVA $73.1 By contrast, GM destroyed $83 Johnson & Johnson in general. 48.8 PG&E 5-Year XVA ($83.2) Chase Manhattan billion. 43.7 Phillips Electronics Pfizer 40.8 Digital Equipment

Source: Finegan & Gressle survey of the 1,700 largest companies traded on a U.S. exchange based on year-end 1996 data ($ Billions). A complete listing is available at www.shareholdervalue.com.

How do you drive MVA?

MVA comes from operations, not finance. MVA depends on the future, not the past.

How do you drive MVA?

MVA comes from operations, not finance. MVA depends on the future, not the past.

The Performance Measurement Challenge

Reconcile the discrete and often conflicting value drivers of a business. Differentiate substantive economic performance from bookkeeping entries. Capture the real time cost of money.

Reconciling Value Drivers

Avoid Mixed Signals

The Traditional Financial Management System

Corporate Office
Investor Relations
EPS

Treasury Management Cost Accounting Capital Budgeting

Discounted Cash Flow Cash Flow

Strategic Planning Human Resources

Market Share, Earnings Growth

Asset Turns

ROE and Net Income

No common denominator of value. Heavily dependent on corporate synthesis and reconciliation of departmental figures. Information transfers slow and inefficient.

Reconciling Value Drivers

Avoid Mixed Signals

The Traditional Financial Management System

The Ideal Financial Management System

Valuation Strategic Planning Annual Budgeting

Investor Relations

Treasury Management

Capital Budgeting Human Resources

Cost Accounting

No common denominator of value. Heavily dependent on corporate synthesis and reconciliation of departmental figures. Information transfers slow and inefficient.

Common language for allocating resources, conducting valuations, measuring performance, and communicating with investors. Minimal corporate synthesis and reconciliation. Information transfers real-time and meaningful.

Reconciling Value Drivers

Avoid Mixed Signals

The Traditional Financial Management System

The Ideal Financial Management System

Valuation Strategic Planning Annual Budgeting

Investor Relations

Treasury Management

Capital Budgeting Human Resources

Cost Accounting

No common denominator of value. Heavily dependent on corporate synthesis and reconciliation of departmental figures. Information transfers slow and inefficient.

Common language for allocating resources, conducting valuations, measuring performance, and communicating with investors. Minimal corporate synthesis and reconciliation. Information transfers real-time and meaningful.

An Integrated Measure of Business Performance

EVA = Operating Profit - Opportunity Cost of Running the Business

Cost of Borrowing?

Sales Cost of Sales Overhead EBIT Tax on Operations NOPAT

Dividend Yield? The return (or expectation) foregone by not investing in a comparably risky portfolio of projectsthe weighted cost of debt and equity capital. Opp. Cost = Cost of Capital x Beg. Capital

An Integrated Measure of Business Performance

EVA = NOPAT - c* x Beg. Capital

EVA can also be expressed as:

EVA = (Return on Capital - Cost of Capital)
x

Beg. Capital

EVA introduces four powerful incentives:

Improve efficiency, and thus returns. Grow, but only if new investments can earn the cost of capital. Redeploy capital from underperforming operations. Manage risk, and therefore the cost of capital.

Value Proposition: EVA Drives MVA

Value Value
PV EVA C

PV NOPAT C

MVA
PV EVA2 PV EVA1

PV EVA3

PV CF3 PV CF2 PV CF1

Capital

Discounted Free Cash Flow

Discounted Economic Value Added

The discounted present value of a companys expected EVA is its market value premium or discount to book value (MVA). A companys discounted EVA plus its level of capital employed will always equal the discounted present value of expected Free Cash Flow. EVA is the only integrated measure of growth and profitability which relates directly to stock value.

Measurement Challenges:

Differentiate substantive performance from bookkeeping:

Acquisition accounting Write-offs and restructuring charges Off balance-sheet financing Expensing of long-term investments

Capture the real cost of money:

Cash-basis versus accrual accounting

Linking pay decisively to EVA

Why are incentives so important?
Pressure on Performance

Executive Talent

Tremendous opportunities Fewer competitive barriers Accelerating change Rapid competitive response Investor pressure

Decisive edge in value creation Highly sought

Strategy: Use performance-based pay to attract top talent and and encourage value creation

The Reality:
Most incentive plans arent designed to drive value creation
Stock and Options

Cash Incentives

Linked to stock price Competitive Line of sight often poor No focus on goals

Mainly annual EPS, ROE goals, capped Weak link to value Battles over fairness

Value-based plans, in contrast, clearly link decisions, results and shareholder value.

The traditional annual incentive plan

$ Bonus

Target

Operating Profit 80% Budget 120%

The EVA-based incentive plan

$ Bonus

Key Features:

No caps (or floors) A bonus bank

Greater leverage

Target Self-adjusting targets Deferred at risk

portion of award
EVA Performance Target

The EVA-based incentive plan: Target-Setting

Targets can reflect:
$ Bonus Uniform improvement level Peer performance Market expectations Target

Key Features:

No caps (or floors) A bonus bank

Greater leverage
Self-adjusting targets EVA

Performance Target

The EVA-based incentive plan: Target-Setting

The expected annual improvement in EVA can be determined from market expectations:
PV EVA

$80

PV EVA PV EVA

MVA

EVA C
Current EVA Capitalized

Present Value of EVA Improvement

$ 30
$100

Capital

$ 50

Effective EVA Implementation Requires:

Management recognition that current financial measures distort capital allocation or weaken incentives to create shareholder value. Understanding and appreciation by Operations, Human Resources and Finance of EVAs role in effecting change. Sufficient investment of time and resources to help managers understand what EVA is and how it should be used in managing their business.

EVA Implementation Process

Step 1 Step 2 Step 3 Step 4 Step 5

Understand and appreciate current readiness for change

Determine strategy (objectives, messages, and media)

Develop training/ communication materials

Rollout

Evaluate Results

Framework Example: A Major Oil & Gas Company

Operating Profit

Distillate Operating Profit

Convenience Store Oper. Profit

Gasoline Gasoline Operating Profit Profit

Lubricants Operating Profit

Car Wash Operating Profit

Product Margin

Total Costs

Volume

Weighted Margin

Variable Costs

Period Costs

Retained Accounts

New Accounts

Grade Ratio

Grade Margin

Premium

Mid-Grade

Regular

Framework Example: A Major Oil & Gas Company

Operating Profit

Distillate Operating Profit

Convenience Store Oper. Profit

Gasoline Gasoline Operating Profit Profit

Lubricants Operating Profit

Car Wash Operating Profit

Product Margin

Total Costs

Volume

Weighted Margin

Variable Costs

Period Costs

Retained Accounts

New Accounts

Grade Ratio

Grade Margin

Premium

Mid-Grade

Regular

Premium

Mid-Grade

Regular

Improved Implementation: Making performance measures line-of-sight

Price Revenue Volume NOPAT Tax Operating Expenses Cost of Goods Sold SG&A Raw Materials Labor Other

EVA
Cost of Capital

Cost of Debt Cost of Equity Capital Charge Fixed Capital Capital Employed Property Inventory Working Capital Receivables Payables Other Good Will Intangibles Plant & Equipment

Legend:

High Impact Medium Impact Low Impact

Common Concerns:

We have too many initiatives already underway; this will just confuse everyone. Its too complicated; nobody will understand it. Were already very successful, so why do we need this? Im investing for the future, but youre measuring todays returns.

You cant compare my SBU to SBU X, were different. We should formulate our strategy first and decide where were trying to go before we start measuring performance. We just convinced everyone that Return on Capital is the most important measure to evaluate performance.

EVA Implementation
If I had to do it over

Keep it simple! Devote greater resources to improving financial literacy. Establish clear line-of-sight between a managers actions and EVA, and EVA and shareholder value. Integrate the EVA initiative with other efforts such as cycle time, customer satisfaction, and balanced scorecard. Develop EVA Coaches to provide continuing support. Gain early buy-in from operations.