|Why do companies tend towards zero EVA?|
A recent study conducted by Stern Stewart on the value creation in companies from different sectors confirmed an interesting characteristic of the economic reality: the tendency to an average of zero for Economic Value Added (EVA). When we elected a sample of roughly one thousand companies, we noticed that certain sectors sustain a positive EVA while others present a negative EVA. In other words, if an ‘economic picture’ of a large group of companies were to be taken, a balanced distribution around zero EVA would be seen. Why does this happen?
EVA is an economic profit measure. It reflects the real value creation of a company after considering the cost of capital, which is a function of the risk of the activities the company engages in and of the total capital invested. Contrary to the accounting profit, zero EVA does not mean that the company “lost money”, but that its return was appropriate to compensate shareholders and creditors.
There are several reasons why companies in a specific economic sector to present a negative EVA: the contraction of their market, the replacement of its products or even cyclical factors such as occur, for example, in companies that depend on commodities or in segments that go through rapid transformations. A negative EVA does not necessarily mean that the company is about to go bankrupt but is a warning for owners to rethink their operating strategies: the capital invested in the company is not being remunerated at a rate that compensates the risk of the business. When facing such a situation, the company should reassess its operations: reallocate assets, develop new products, search out new markets, invest in more profitable projects or even divest and use the money for other businesses.
Companies with positive EVAs should also stay alert. They face the challenge of maintaining, for as long as possible, the competitive advantages that grant them returns higher than their opportunity costs. Sectors with positive EVAs tend to face a more competitive environment once the perception of higher profitability attracts new competitors to the segment.
In the latter case, generated economic profit is diluted amongst a higher number of market players. It is this dynamic process that leads such sectors to return to the average of zero EVA. As time goes by, it is possible to identify a natural migration of companies located in positive levels of EVA to negative levels and vice-versa. These motions are due to the constant process of renovation of both the economy and society.
Thus, the challenges of a company may be summarized in three key points: 1) Is the business creating enough value to compensate the total invested capital and the risk of the activity? 2) Which activities or products are creating and which are destroying value? 3) How can the company add value and maintain this tendency over the long term?
For all these questions, EVA is a powerful tool to help managers and shareholders seek solutions. EVA allows the rationalization of a company’s management whether in macro or microsegmented levels. This means that, besides working as a thermometer at the consolidated level, it can also be used to measure specific business units or individual activities within a company.
However, the most important result of the study is that EVA generation is directly related to investors’ perception. In other words, the market recognizes and positively prices companies that generate economic profit. Companies presenting positive EVAs are better evaluated by investors and present higher market multiples.
For all these reasons, EVA acts as an important management tool that reflects the company’s value generation and helps the decision-making process, aiming to maximize companies’ value.