The EVA Challenge: Implementing Value-Added Change in An

The EVA Challenge Implementing Value-Added Change in an Organization By Joel M. Stern and John S. Shiely, with Irwin Ross John Wiley & Sons, Inc. New York • Chichester • Weinheim • Brisbane • Singapore • Toronto The EVA Challenge Advance Comments on The EVA Challenge “Moving beyond describing the financial calculation of EVA and EVA-based bonus schemes, Stern and Shiely build an integrated approach to managing complex organiza- tions in dynamic environments. Spanning recent research in strategy, management, accounting, finance, and economics, they offer a comprehensive framework of corporate governance—getting managers to act in shareholders’ interest.” —Jerold Zimmerman, Ronald L. Bittner Professor, Simon School, University of Rochester “There is nothing more practical than a good theory. The ideas developed in this book rest on the seminal contributions of two Nobel laureates, Merton Miller and Franco Modigliani, and their subsequent Chicago students such as Fama, Scholes, Jensen, and Joel Stern himself. I found this book very practical in developing a firm’s value creation strategy that benefits all stakeholders regardless of market considerations.” —Robert S. Hamada, Dean and Edward Eagle Brown Distinguished Service Professor of Finance “Stern and Shiely have produced a winner. The EVA Challenge not only serves as a useful how-to guide, but an important road map for anyone implementing a performance system that will ultimately provide value creation for the shareholder.” —C. B. Rogers, Jr., former Chairman and Chief Execu- tive Officer, Equifax “The EVA Challenge is a path-breaking book, lucidly written, which reveals the underlying economic reality of a firm, the way to measure the true profit and loss.” —Daniel Bell, Henry Ford II Professor of Social Sci- ences, Harvard University, Emeritus “A firm’s success depends crucially on its ability to monitor the performance of its management team and to reward them correspondingly. Managers who want to understand how EVA is helping firms to tackle these twin problems cannot do better than to read The EVA Challenge.” —Richard Brealey, Visiting Professor of Finance, Lon- don Business School “Joel Stern has played a crucial role in advancing our knowledge of how to design company performance and managerial compensation schemes....it is grounded in a strong intellectual framework that economists can recognize....a readable and hands-on-approach....[that] will interest both practitioners and students of finance.” —Julian Franks, Professor of Finance, London Business School “As Joel Stern and John Shiely vividly demonstrate, the real key to success with EVA is providing EVA training and incentives at all levels in the organization. At SPX, where virtually every one of our employees is on an EVA bonus plan, the system has helped us achieve breakthroughs in efficiency and profitability that few people thought possible.” —John B. Blystone, Chairman, President, and CEO, SPX Corporation “To be sure, this book is an indispensable guide for any organization considering a move to EVA. But it’s also a highly readable primer for anyone who simply wants to learn more about what EVA can mean for companies, their shareholders and stakeholders.” —James D. Ericson, Chairman and Chief Executive Officer, Northwestern Mutual The EVA Challenge Implementing Value-Added Change in an Organization By Joel M. Stern and John S. Shiely, with Irwin Ross John Wiley & Sons, Inc. New York • Chichester • Weinheim • Brisbane • Singapore • Toronto This book is printed on acid-free paper. ➇ Copyright © 2001 by Joel M. Stern and John S. Shiely. All rights reserved. Published by John Wiley & Sons, Inc. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850- 6008, E-Mail: [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. EVA® is a registered trademark of Stern Stewart & Co. Library of Congress Cataloging-in-Publication Data: Stern, Joel M. The EVA challenge : implementing value added change in an organization / by Joel M. Stern and John S. Shiely with Irwin Ross. p. cm. — (Wiley finance) ISBN 0-471-40555-8 (cloth: alk. paper) 1. Economic value added. I. Shiely, John S. II. Ross, Irwin III. Title. IV. Wiley finance series. HG4028.V3 S83 2001 658.15—dc21 00-047993 Printed in the United States of America. 10987654321 Contents 1 The Problem 1 2 The Solution 15 3 The Need for a Winning Strategy and Organization 27 4 The Road Map to Value Creation 51 5 The Changes Wrought by EVA 71 6 Extending EVA to the Shop Floor 85 7 Getting the Message Out: Training and Communications 107 8 EVA and Acquisitions 123 9 EVA Incentives 147 10 How EVA Can Fail 159 11 New Frontiers: Real Options and Forward-Looking EVA 167 12 25 Questions 179 13 Recipe for Success 203 Epilogue: EVA and the “New Economy,” by Gregory V. Milano 209 Acknowledgments 233 Index 245 v Chapter 1 The Problem Back in the early 1960s, one of the authors of this volume was asked by an old family friend what he was studying at the University of Chicago. “I’m trying to come up with what determines the value of a company,” said the young Joel Stern. “Even like my store?” asked the old friend, who ran a mom-and-pop grocery store. “Of course.” The grocer was incredulous: “You’re going to school for that! Come down to the store tomorrow and I’ll show you what determines the value of a company.” The next morning, he escorted a skeptical Joel behind the counter and pointed to a cigar box. “This is where we put the money,” he explained. “If the lid is rising during the day, it means we’re doing fine.” This simple insight into the basic importance of cash in valuing a business has always been known by the entrepreneur. Indeed, he can often work it out on the back of an envelope, comparing his total expected return with what he could plausibly earn elsewhere with the same amount of money at the same level of risk—in other words, the opportunity cost of capital. What has befogged this insight and pre- vented most investors from making these calculations has been two major developments in American capitalism: (1) the split between 1 2 The EVA Challenge ownership and control of publicly held corporations and (2) the widespread acceptance of accounting measurements to gauge corporate value, a purpose for which they were never intended. To start with the first point: the essence of the problem is that al- though numerous shareholders own a public corporation, control over its operations is in the hands of professional managers, who typically hold relatively few shares and whose interests often diverge from those of the silent majority of shareholders. Moreover, the managers possess detailed information about the company’s prospects that outside shareholders lack, despite the best efforts of security an- alysts to inform them. The divorce between ownership and control had been going on for a long time, and was by no means a secret when, in 1932, the subject was explored in depth in a blockbuster book, The Modern Corporation and Private Property, by two Columbia University pro- fessors, Adolf A. Berle Jr. and Gardiner C. Means. The authors chronicled the growth of the modern corporation in the United States from its start in the late eighteenth century, when companies built bridges, canals, and turnpikes. Early in the next century came the extension of the corporate form to the textile industry, its later dominance of the railroad industry and, afterward, of oil, mining, telephone, steel, and almost every other industry. Berle and Means boldly asserted, in 1932, that so powerful were the large corporations that “private initiative” was now nonexistent, that self-perpetuating groups of managers dominated the economy and often pursued agendas contrary to the interests of owners and, presumably, to that of the country as a whole. Their rhetoric at times seems excessive, and may well have been influenced by the book’s publication in the depths of the Great Depression. Timing may also have heightened the impact of the book, but its renown has ex- tended over the decades, and it is still in print. It is a book worth recalling, for it foreshadows the present con- cern with “corporate governance”—a high-flown term for a search The Problem 3 for systems to get managers to act in the interests of shareholders. For a given degree of risk, shareholders obviously seek the highest total return—the sum of dividend payments plus share price ap- preciation. Managers, by contrast, often tend to be preoccupied by their personal pecuniary interests. The book’s examples of con- flicts of interest between managers and shareholders are both hair- raising and anachronistic—and are doubtless evidence that things have improved since 1932. Thus, it gives many examples of self- dealing, with managers typically funneling purchases to suppliers that they covertly own, as well as various types of fraud that have become less common in the years since that powerful police agency, the Securities and Exchange Commission (SEC), was es- tablished in 1934.

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