Prof. Pallavi Singh
Faculty of Finance
ICFAI National College
Rewa, M.P.

While in a business schools, we get to learn the various measures adopted by analysts to gauge the performance of companies and are able to fathom abbreviations like EPS, ROCE and RONW but many of us are not comfortable with EVA, which is a clear cut winner to the traditional accounting measure – EPS.

Growth in EPS is admittedly a seductive corporate goal. For one thing, EPS is the accepted "bottom-line" in accounting view of things, but of course accountants don't set stock prices. It also certainly appears as if the market reacts strongly to a management's ability to meets its quarterly EPS targets. But that is just an illusion. Getting off the EPS bandwagon becomes even more difficult when so many executives have incentive pay linked to EPS    

The superficial attraction of EPS is that it is grounded in "Accounting Model of Value". It states that a company's stock price is the result of multiplying its EPS by its P/E multiple (price to earning multiple):-
Price= EPS * PE

According to this mathematical tautology a company that has RS 5in EPS and that trades for 20 times its earnings is worth Rs100 a share, i.e.,
Rs 100=5 * 20

This accounting valuation formula suggests that if EPS increases, stock prices will go up and vice-versa. For example, if EPS rises to Rs6, the sock price will climb to RS 120 per share and if EPS falls to Rs 4 it will tumble down to Rs 80. The appeal of this model is its utter simplicity but with a weakness in failing to explain the reality.

The underlying assumption of the accounting model is that P/E multiple will remain same regardless of what is driving EPS up or down, which is highly theoretical proposition and is a wrong practice.

P/E multiple change all the time , in the wake of new corporate strategies, investments, in reaction to shifting returns to capital, growth rates and in response to new financial structures and reporting practices. To cut short, P/e ratios move to reflect a change in the quality of a company's earnings and that fact alone makes the mere quantity of an EPS extremely unreliable gauge of corporate performance and stock market value.

These days one finds several cases of companies that have shown better earnings but crumbled in no time. Enron is one such case, which failed due to the managements laser focus on EPS. Their EPS mania drove the management to over invest capital in their business for inadequate returns and over-leveraged their balance sheets.

The demise of Enron proves that companies trying to manage EPS are asking for trouble as the excerpts of 2000 Annual Reports revealed the company's love affair with EPS-

    "Enron's performance in 2000 was a success by any measure…….. The company's net income reached a record in 2000. Enron is laser focused on EPS and we continue to strong earnings performance."

While Enron's debacle is by itself a strong indication that something must be terribly wrong with slavishly worshipping an EPS idol and almost all of Enron's travail can be traced to their "laser focus on EPS", to comment even a "penlight- focus" on EPS is a big mistake.

Enron is a classic example of over investment syndrome. Driven by their desire to maximize EPS growth, it' s management sunk billions in capital into low returning investments- in off shore utilities, in broad band build outs and into risky and hard to value energy supply contracts. James Chanos, the renowned investor who shorted Enron stock a year before the bankruptcy, betting on its fall, based his decision on measuring that Enron was only earning a 7% return on its capital, for less than he thought investors should expect from a risky company like Enron.

The other strategy used by Enron to boost EPS was over-leveraging the balance sheet, it refrained from issuing new common shares to finance growth for fear of diluting EPS, as a result, they employed debt financing o the hilt and beyond the brink of financial prudence, leading to over-leveraging their balance sheets, so that when things fall apart, far too little equity was available to cushion the blow.

Former Enron CEO Jeffery Skilling admitted that they fall prey to a classic bank run. But a well managed company would not permit the firm or its stakeholders to be exposed to the risk of a run. Well managed companies maintain prudent balance of debt and equity, considering the risk of business. The problem is that EPS fanatic companies will always be tempted to live over edge, to borrow too much, to raise too few new shares, just to keep their EPS growth as high as possible.

Enron didn't have to go bankrupt to make over-leveraging of its balance sheet a bad idea. Raising debt instead of equity does help a company to boost its EPS as it avoids new share dilution. But relying on debt has an unfortunate and countervailing side effect. It raises the risk in EPS and reduces P/E multiple investors will be wiling to pay.

This "bet the ranch" financial strategy violated one of the most basic principles of sound corporate finance policy- risky growth should be financed with equity, not debt, and thus despite having constant growth in EPS and net income. Enron witnessed such a huge pitfall which could have been prevented provided they would have peeped into their EVA, which was clear indicator of steep destruction of the capital as they were not generating sufficient returns as compared to the capital employed, which is witnessed from the chart below:

Enron is not solely alone in manipulating accounting rules to keep earnings growth on track, almost every company favorably interprets "accounting principles" in order to boost and stabilize its reported profit, even if not to the fraudulent degree of Enron. Managers have enormous latitude to massage EPS, even within the boundaries of established accounting rules. What's needed at this point of time is nothing less than a wholesale rejection of the accounting model –"earnings management game". EPS should no longer be used as a corporate goal, as a performance measure or as the basis of executive incentive compensation.

The indicator that's demanded is an –"Economic Management Model" firmly grounded in the fundamentals of value creation. In order to overcome the limitations of accounting model to measure financial performance Stern Stewart, UK based consulting firm unveiled EVA – Economic Value Added in the year 1990, but it's origin as Economic Profit dates back to early 1900's.

EVA measures whether the operating profit is sufficient enough to cover cost of capital, i.e., shareholders must earn sufficient returns for the risk they have taken in investing their money. If a company's EVA is negative, the firm is destroying shareholders wealth even though it may be reporting a positive and growing EPS. 

EVA has been successfully employed in nearly 400 companies worldwide, including well known firms as Coca Cola, Siemens & Sony. According to Business standard KPMG's study major shareholder value generating companies were IOC, VSNL, Hindustan Lever, GAIL, ITC where as the worst value destroyers were Essar Shipping's, Flex Industries and Videocon International.

Over the years, financial analysts have found conventional accounting to be misleading, under which most companies appear profitable while many in fact are not. Peter Drucker had put the matter in Harvard Business Review Article-

"Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had genuine profits. The enterprise still returns less to the economy than it devours in resource. Until than it does not creates wealth; it destroys it. EVA is an excellent indicator of wealth creation."

It sets a high, market competitive hurdle, for higher than just the borrowing cost. Companies that will increase their EVA will also necessarily increase their EPS. But the opposite is not the case. It is easy for a firm to misallocate or invest capital, increase its sales, gain market share, add to its earnings and EPS and yet reduce its EVA and its stock price, as has been witnessed in Enron's case.

EPS simply sets too low a standard to be meaningful performance measure in today's demanding capital markets. Compared to EPS, EVA makes it clear that capital is expenditure to use. It also automatically overcomes the "3 overs" of EPS game, especially when the companies use EVA for incentive plans, viz. –

  • Managers bonus set as a percent of improvement in EVA as against targeted.
  • Discourages over-leveraging of balance sheet, by even including significant off balance sheet items no matter how they are financed- claiming out of sight is no longer out of mind.
  • Discourages managers to use over the top accounting and over reacting to conventional accounting indicators like EPS.

EPS is the opium of executive suite; it is the Don Juan of corporate values. As Enron discovered, worshipping at the EPS alter can lift a top team to a prominent pedestal in the short run but drag them down to a fiery grave in the longer run. Once the management jumps to EPS treadmill it becomes difficult to escape impunity, as the company gets tempted to fuel growth by abusing their balance sheet. They will likely make dumb strategic decisions like postponing promising research or delaying a restructuring, all to keep up the EPS, dragging themselves to earning management game and spending less time on economics of their business. As Enron apparently did, that reporting is reality, so bend it to suit your purposes.

By comparing the EPS, EVA is a far better way to keep score, a more challenging and meaningful goal, a more useful decision guide and truly a superior metric for determining incentive compensation. Sensing the benefits of EVA (GCPL) Godrej found the solutions to its problems and decided to introduce it. Adi Godrej clarified this point by saying-"At GCPL we have used EVA not only as a financial tool but also as a way of structuring performance linked variable remuneration. This is a new concept in the Indian Corporate world and because of its novelty----- EVA was accepted with great enthusiasm within the company."

The list of companies turning their story using EVA is not exhaustive; Herman Miller Inc. had a rich history and culture, great products and talented employees. The economy was strong, industry was growing and sales were being made even faster but the results ere not showing and here the company found EVA and in two years the company turned the corner by improving their sales from $ 1 billion to $1.5 billion with the same amount of capital. Their Eva was $40 million- an increase of 300% over the previous years EVA.

Eva helped the company identify their waste in both their cost and use of capital and reducing the inventory by 24%, receivables by 22% and increasing the sales by 38%.

For Herman Miller, EVA was a great tool. The concept is picking up in India, many companies are making EVA a part of their annual reports viz. Infosys, HLL and Dr Reddy's Laboratories…. Etc, besides it is also used by credit rating agencies for rating the companies. So next time a company or a scholar in a mood to analyze financial performance, know what to look for……..?   EVA!

Prof. Pallavi Singh
Faculty of Finance
ICFAI National College
Rewa, M.P.

Source: E-mail May 21, 2006


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