Haunted by a Bad Growth Strategy? Here’s One Fix

There’s a new metric in town called EVA momentum, and it measures whether your business plan is producing profitable growth.
Marie LeoneOctober 28, 2011

Every year, sometime near the cusp of Halloween, CFOs think about a frightening prospect. What if the business plans and budgets submitted by other executives, the ones finance chiefs spend months scrutinizing and scrubbing, don’t produce the intended results over the next year? And what if they fall short of what investors expect, even if they do produce what the line managers promise?

While there is no escaping the unexpected events that can derail business plans, a relatively new performance ratio, called EVA momentum, may help CFOs get a better handle on measuring and keeping growth plans on track. In a nutshell, the ratio measures the change in a company’s economic profit divided by sales in the prior period. Dividing by prior sales converts EVA, or economic value added, from a monetary measure of economic profit to a ratio, and scales the growth in EVA to the sales size of the business. As a result, the measure is comparable across companies of different size and those in different industries, including various lines of business.

The key aspect of the momentum metric is that it relies on EVA rather than a measure of profit based on generally accepted accounting principles. The difference is that EVA includes the cost of all corporate capital, equity, and debt, while equity capital is left out of GAAP profit calculations. As a result, EVA counts as “profit” only the returns a company earns in excess of a minimum acceptable return to shareholders, says Bennett Stewart, who as chairman of EVA Dimensions LLC developed the momentum metric, and is a co-creator of EVA. EVA also “corrects” GAAP treatments that depart from economic reality, such as expensing investments in research and development.

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Although EVA metrics are not about to replace GAAP measures, they do offer intriguing possibilities for CFOs to keep close tabs on growth performance. In practice, EVA momentum measures the change in a company’s profitability from one period to the next, including the impact of sales growth on economic returns. Because it measures the change in profitability, and because of the way it is calculated, EVA momentum makes it possible to directly compare companies that are losing money but getting better with companies that are churning out stellar profits but may not be achieving increased returns for their owners.

Consider the example of software maker Aspen Technologies. A look at the company’s financial results for the four quarters ended in June shows negative operating income of $55 million on revenues of $198 million. However, when compared with all nonfinancial companies in the Russell 3000 with stock prices that exceed $5 per share, Aspen topped the software industry in EVA momentum during the period, with a score of 21.3%. That is, Aspen improved its EVA by an amount equal to 21.3% of its base sales in the prior four quarters. While Aspen still had an economic loss, it reduced the loss by so much that the company ranked first by industry and 20th overall in the Russell 3000. (To see Q2 EVA rankings by industry, click here.)

Aspen cut its economic loss by a third over the last four quarters, from a negative $106 million to a negative $71 million, giving the company a 28% improvement in its EVA margin (see column marked “Delta EVA Margin” in rankings chart). “That’s a huge improvement,” notes Stewart, who says the median EVA momentum performance for the nonfinancial companies in the Russell 3000 universe was 1.1% in the four quarters ended in June, and a score of 8% was way up at the 90th percentile. Aspen was at the 99th percentile, and “it doesn’t get much better than that,” adds Stewart.

The assumption that can be drawn from Aspen’s momentum score is that its business plan, which is now delivering a 19% sales growth rate, is working with regard to improving profitability performance. Aspen is running slightly ahead of the 17% industry average for sales growth.

Meanwhile, software industry behemoth Oracle is having a good year, too, although its EVA momentum score reflects a less-dramatic climb compared with Aspen’s. Oracle’s EVA momentum was 6.1% over the most-recent four quarters, meaning the company’s EVA increased by a little more than 6% of its trailing four quarters sales. The company picked up most of its EVA momentum improvement, 4.4%, from profitable sales growth, and 1.7% from improvement in its EVA margin. (The contribution from profitable growth is calculated by multiplying Oracle’s 24.7% sales growth by its concluding EVA margin of 17.7%.) Compared with other Russell 3000 companies, Oracle ranked 197th based on EVA momentum. With 1,815 nonfinancial companies with share prices above $5, that puts Oracle at the 89th percentile.

In practical terms, boosting EVA momentum usually comes from three types of improvement, says Stewart: pricing power, product mix, and process improvements. Pricing power is the ability to charge handsomely for products and services to create a high-margin business; a strong product portfolio produces natural hedges against fickle consumer demand; and process improvement involves increasing the efficiency of company operations. Managing for any one or a combination of these improvements usually results in an increase in EVA momentum.

EVA momentum has a couple of other interesting and useful features. It has a clear dividing line between good and bad performance. That line is zero EVA momentum. Zero means that EVA has not changed from one period to the next — that a company basically is running in place. If EVA momentum is positive, that’s good because it means economic profits have increased. If it’s negative, that’s bad because economic profits have declined.

Further, EVA momentum is the only performance ratio for which a higher level always is better than a lower one. That’s not the case with ratios such as return on capital, return on assets, or even earnings per share, which can rise when profitable performance is actually deteriorating; consider that EPS goes up when a company repurchases shares. In comparison, if EVA momentum is positive, a higher level always means economic profits have increased more. If it’s negative, a less-negative number means economic losses have declined less.

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