The Truth About Economic Value Added

By Gary D. Burkette and Timothy P. Hedley

In Search of Reality

Does a bottom line reflecting only GAAP give a true picture of a company's performance? Using GAAP based financial statements, the authors take us through some of the adjustments that are necessary to reflect economic profit. Among other items, they demonstrate how a loss from operations may actually be hiding a positive economic net operating income or how some current operating expenses written off under GAAP will be providing future benefits. They advocate the determination of economic profit as a significant means for understanding performance evaluation in both for-profit and not-for-profit organizations.

A detailed example helps fill in the details.

Recently, business magazines and journals have included articles extolling the benefits of economic value added (EVA), hereafter referred to as economic profit, a tool that can be used to evaluate the performance of almost any business. The use of the economic profit concept is credited by several large companies, such as AT&T, Briggs and Stratton, and Coca-Cola for enhanced performance. One widely held belief among managers of these firms is that using the concept more closely aligns the interests of managers with those of shareholders.

Using the concept is not limited to for-profit enterprises; several public sector and not-for-profit enterprises are also interested. For example, the U.S. Postal Service has hired Stern Stewart, a consulting firm specializing in economic profit calculations to assist in implementing the concept as a performance measurement. EVA is also Stern Stewart and Co.'s trade name for their method of calculating economic profit.

Many investors have also adopted economic profit analysis, using it to evaluate a company's potential for long-term stock price appreciation.

Background

The idea of calculating economic profit is neither new nor complicated. Alfred Marshall originally suggested that a firm must do more than generate net income as defined by generally accepted accounting principles. To survive in the long term, firms must generate sufficient profit to cover the cost of all invested capital. Economic profit performance measurement applies the actual cost of capital--including both debt and equity--used by the business to determine if a company is actually generating economic value.

Calculating a company's economic profit initially appears to be rudimentary: Begin with after-tax operating income and deduct a charge for the cost of equity capital. This method, however, is incomplete. To properly calculate economic profit, adjustments must be made to after-tax operating income and then the total capital investment in the company computed. The necessary adjustments to after-tax operating income include subtleties frequently overlooked when calculating economic profit.

While the information needed to compute economic profit is generally available in GAAP-based financial statements, reconsideration and rearrangement of some balance sheet and income statement amounts are necessary. Whether justified or not, many articles in the business press concerned with calculating economic profit include criticism of GAAP-based financial statements and the resulting treatment of certain expenditures. For example, while GAAP calls for deducting interest charges on debt when calculating net income, it ignores the cost of equity capital. If after this deduction for equity capital the bottom line is negative, the company is not creating economic value despite a positive GAAP-based net income.

Calculating economic profit requires other changes to GAAP-based net income. Certain expenditures, such as research and development and employee training costs are capitalized and amortized over time rather than expensed in the year incurred as required by GAAP. The simple example below illustrates these differences.

Concept of Economic Profit Calculations

Using EVA Company's financial statements (Exhibits 1 and 2) as an example, economic profit might be calculated as follows:

1. Calculate the company's cost of equity capital. Historically, for an average-risk company, this is generally about six percentage points higher than the interest rate on long-term government bonds. Assuming long-term government bonds yield 6.5%, the cost of equity would be 12.5%.

2. Calculate the weighted average cost of capital for the company. The company has a capital structure of approximately 40% debt, costing 6.2%, and 60% equity, therefore the weighted average cost of capital would be:

(.6 x 12.5%)+(.4 x 6.2%) = 9.98%

3. Calculate adjusted operating income. Add back interest expense, net of any tax effects, and other noncash charges to after-tax operating income. This step is missed in many business press discussions of economic profit. Assume an effective tax rate of 20%.

1995 1996

Income (loss) from operations $(3,477) $7,748

Interest expense, net of taxes 1995: ($4,035 x .8) 3,228

1996: ($3,762 x .8) 3,010

Loss on sale of assets, net of taxes 1995: ($5,453 x .8) 4,362 -0-

Adjusted operating income $4,113 $10,758

4. Calculate operating income plus. Add back expenses providing a future benefit (training, research, and development), net of any tax effects, to the adjusted operating income calculated in step 3.

1995 1996

Adjusted operating income $4,113 $10,758

Research and development costs, net of taxes

1995: ($51,938 x .8) 41,550

1996: ($58,435 x .8) 46,748

Amortization of 1995 R&D

($51,938 / 5 yrs.) (10,388)

Adjusted operating income plus expenses providing future benefits $45,663 $47,118

5. Calculate net assets employed on a book basis. Add together balance sheet amounts for working capital, property and equipment and other long-term investments.

1995 1996

Current assets $294,860 $302,574

Current liabilities 133,011 134,107

Working capital 161,849 168,467

Long-term assets 119,293 112,570

Net assets $281,142 $281,037

6. Calculate capital investment. Add items classified as current operating expenses that will provide the company benefits in future periods. These would include, for example, employee training and research and development costs. This may require that you examine the company's past financial statements.

1995 1996

Total from 5 above $281,142 $281,037

Research and development costs 51,938 99,985*

Total capital investment $333,080 $381,022

*$58,435+80% of $51,938

7. Calculate the cost of capital. Multiply the weighted average cost of capital calculated in step 2 by the total capital investment calculated in 6.

1995: (9.98% x $333,080) = $33,241

1996: (9.98% x $381,022) = $38,026

8. Calculate economic profit. Subtract the capital charge calculated in 7 from the readjusted operating income calculated in 4. The result is the company's economic profit.

1995 1996

Readjusted operating income $45,663 $47,118

Capital charge 33,241 38,026

Economic profit $12,422 $9,092

The positive results in 8 suggest that the company is generating economic value with invested capital. Negative results would suggest that invested capital is not being used effectively and might be better employed elsewhere.

Employing the Economic Profit Concept

Companies, both large and small, are using economic profit calculations in several ways.

As a Measure of Corporate and Divisional Performance. To improve long-term performance, company management should use existing assets, investing in projects where expected returns exceed capital costs or by divesting of projects, product lines, or divisions, where returns have not and are not expected to exceed capital costs. Economic profit is improved by each of these actions, providing an effective instrument for measuring performance.

As a Compensation Base. Using economic profit as a management compensation base is credited with better aligning stockholder and management interests. For example, a division manager's incentive compensation might be based on a combination of corporate economic profit, divisional economic profit, and other objectives. Because the economic profit concept helps to alter long-term thinking, including it as an element in determining management compensation could enhance long-term profitability, more closely aligning stockholder and management interests. Managers may initially resist economic profit-based compensation, but this is usually overcome as they are educated about the measure and satisfied about the fundamental fairness of its application.

To Increase Manager Awareness of Stockholder Interests. As noted earlier, economic profit calculations create a situation where managers are in a position more akin to shareholders. Equity capital can no longer be considered free, and the long-term perspective is more consistent with a goal of maximizing shareholder wealth. Managers are compensated for generating a return on all capital employed, regardless of its source or how it is used.

To Emphasize Long-Term Importance and Benefits of R and D and Employee Training. Employee training and research and development costs provide long-term benefits to a company giving managers an incentive to make such investments. Some companies consider this so important that all research and development costs are capitalized in economic profit calculations, not just those that result in tangible products or product improvements.

To Increase Firm Value. After a period of implementation and adjustment, many companies, like Quaker Oats, CSX and others, experienced stock price appreciation in excess of that experienced by the overall market. This was largely due to increased managerial awareness of stockholder interests and a longer-term thinking perspective brought about as a result of implementing the concept. *

Gary D. Burkette, PhD, CPA, and Timothy P. Hedley, PhD, CPA, are assistant professors of accounting at East Tennessee State University.