Glossary

NOPAT is net operating profit after taxes. It is operating profit before any interest or financing charges are deducted, measured net of period charges for depreciation and amortization, and after taxes computed using a smoothed normal tax provision, net of the cost of capital saved from deferring taxes, and after corrective adjustments to remedy accounting distortions. As such, it estimates the free cash flow from operations that is distributable after ensuring that tangible and intangible assets needed to sustain the profit can be replenished.

Capital is net business assets. It is all assets used in business operations, net of trade funding from accounts payable and accrued expenses. It is also equal to the total amount of debt and equity raised from investors or retained from earnings. Capital is measured after making adjustments to remedy accounting distortions. For instance, it is measured net of excess cash, net of deferred-tax assets, and net of pension and retirement assets, but including leased assets, and after capitalizing and amortizing research and development (R&D) and advertising spending over time. EVA Dimensions’ reports display the amount of capital in place as of the end of each period, but the amounts used in the computation of EVA and return on capital are averages of capital.

Cost of capital (COC) is the minimum rate of return required to compensate lenders and shareholders for risk. It is not an actual cash cost that a company must pay or that accountants record. It is an invisible but nevertheless very real opportunity cost—the cost to investors of giving up the opportunity to invest their capital elsewhere. It is thus equal to the rate of return that the firm’s lenders and shareholders could expect to earn from buying a portfolio of stocks and bonds that matches the blended risk profile of the firm’s debt and equity. It is estimated in three steps, starting with the relatively risk-free yield prevailing on 10-year government bonds that sets a minimum return requirement for all companies, then adding a premium to compensate investors for bearing the firm’s business risk (i.e., for the inherent variability in NOPAT profit over a business cycle), and third, subtracting a discount to reflect the benefit of using tax-deductible debt as a capital structure component in place of pure equity.

Capital charge is NOPAT needed to earn the cost of capital return on the firm’s capital. It is determined by multiplying the cost of capital times the average amount of capital in the business over the period. It is how large NOPAT would need to be to enable the firm to pay interest on its debts, after tax, and leave a profit remainder that would give its shareholders a minimum acceptable return on the equity they’ve put in the firm. Only when NOPAT is above that threshold has management truly added value to the resources placed at its disposal, compared to alternative market uses for the capital.

The capital charge can thus be thought of as an objective profit performance target for NOPAT that is set in the market by benchmarking the firm against its capital market competitors, as opposed to being set internally by the board or budget. As management adds more capital, the capital charge profit standard is automatically raised, and as management decides to or is able to withdraw capital from its business, the market-demanded NOPAT profit bar is automatically lowered. The capital charge is thus an empowering mechanism that enables all employees to tell a good decision from a bad one without having to ask headquarters for guidance.

(As a technical matter, the capital charge computed for a four-quarter period is the sum of the capital charges for the four quarters, where each is based on the average capital outstanding over each quarter times the quarterly cost of capital rate prevailing over the quarter; this procedure provides an accurate continuous reading of the hurdle charge, even when capital spending is lumpy over a year; yet it cannot be precisely derived by the data furnished in the EVA Dimensions tables.)

EVA (economic value added) is NOPAT minus capital charge. It measures the firm’s economic profit—the profit remaining after deducting all costs, including the cost of giving the firm’s investors a full, fair, and competitive return on their investment in the business. EVA consolidates income efficiency, asset management, profitable growth, and strategic retrenchment into a single, comprehensive net profit score. It is the only profit measure that fully and correctly increases when balance sheet assets decrease. And unlike EBIT, EBITDA, or EPS, EVA does not increase unless growth covers the full cost of incremental capital. It recognizes only quality growth, and ruthlessly reveals the profit shortfalls incurred by firms that purchase growth at the expense of earning a decent return on their investments.

EVA also counters the tendency of companies (or business divisions) that are already earning high margins and returns to milk them—to slow growth in order to maintain high performance ratios. All growth that produces returns higher than the cost of capital will cause EVA to increase, even if existing margins or rates of return are diluted. A goal to increase EVA therefore puts a Bunsen burner under the best businesses to keep scaling, growing, innovating, and investing rather than to rest on their laurels, and, it offers business teams that are navigating tough turnaround lines the opportunity to shine and compete for resources by making the negative EVA less negative.

In short, a focus on growing EVA is the simplest, surest, and most direct way to align management with the mission to maximize the firm’s net present value and its stock price, and to provide line teams with all the right incentives and insights into decision trade-offs.

Return on capital (ROC) is NOPAT/average capital; it is the after-tax rate of return on net business assets. Unlike return on equity (ROE), ROC is unaffected by changes in interest rates or the firm’s debt/equity mix. It measures business productivity performance sans financial distortion. ROC is directly comparable to the firm’s COC as a benchmark, and as such, it offers an insight into value creation and destruction. When ROC is greater than COC, EVA is positive and value is added to the investors’ capital, and when ROC is less than COC, EVA is negative and value is eroded.

One way to think about increasing EVA is thus to strive to earn a higher return on existing capital, to invest capital to support growth over the full cost of the capital, and to release capital from assets and activities that cannot cover the cost of capital. While that’s true and helpful, it couches the EVA drivers in terms of managing and investing capital and earning returns on capital. That appeals to the finance crowd, but it is a lot less intuitive to line teams than is a sales-based approach to measuring, analyzing, and improving EVA. It is time to bury return on net assets (RONA) and the DuPont ROI formula, and replace them with the EVA return on sales method (see EVA Margin and EVA Momentum for further details).

EVA Spread is the ratio of EVA to capital; it is the EVA yield on capital, and mathematically the same as ROC minus COC (i.e., it is the percentage spread between the return on capital and the cost of capital). Putting it in terms of portfolio management, EVA Spread is the firm’s alpha—the excess return above a risk-relevant benchmark return. If the spread is zero, the firm is just covering its overall costs and is breaking even on EVA.

EVA Margin is the ratio of EVA to sales; it is the firm’s true economic profit margin covering income efficiency and asset management. Unlike EBIT and EBITDA margins, which are inflated by the margin requirements of capital-intensive businesses, EVA Margins are not biased in favor of capital-intensive business models, because any added capital is a cost to the EVA Margin. As a result, even firms that differ as much as the capital-mongering chip maker Intel and the incredibly capital-lean consumer staples retailer Wal-Mart can be meaningfully compared in terms of their EVA Margins, whereas they are totally incomparable on other barometers.

EVA Margins also neutralize sourcing decisions. By outsourcing, firms shift the capital costs they would bear on their own balance sheets into the prices they pay to outside vendors. As a result, operating margins decline—a misleading signal—but capital turns speed up, leaving EVA Margin as the reliable arbiter of the relative merits of alternate sourcing strategies.

EVA Margins reveal, as no other margin measure can, the true effective business model productivity that survives at the bottom line, once all costs are netted out, no matter whether the costs are operating costs that enter on the income statement or capital costs that flow from the balance sheet. Broad-based results for the market universe are therefore relevant benchmarks for any firm.

For reference, over the past 20 years, the median Russell 3000 EVA Margin was just 0.5 percent (a sensible economic outcome that indicates business markets are as a rule quite frustratingly EVA competitive, as expected); the 75th percentile firm earned an EVA Margin of 4 percent to 5 percent, on average, and the 90th percentile firm earned 9 percent to 10 percent, on average. It is only the rare firm that earns over a 10 percent EVA Margin (whereas EBITDA margins over 10 percent are commonplace). EVA Margins are also frequently close to zero, or even negative, which is why so many firms that grow sales and book earnings are not really in the business of growing value, an insight they would more readily appreciate if they paid more attention to their EVA Margin metrics.

Besides benchmarking and grading performance, and serving as a guide to business model profitability, EVA Margin can be used as a practical tool to help managers improve performance productivity. Dissecting the Margin and tracing it to the underlying drivers (as is shown on the EVA Margin schedule) can reveal opportunities to construct a higher-performing business model, for example.

The larger point in all this is that with EVA, capital is a cost, an understandable charge to earnings like any other, and not a divisor as it is with an ROI or RONA calculation. Capital is simply a charge to EVA and to the EVA profit margin, conceptually no different than a charge in cost of goods sold. And once the cost of capital has been deducted from profit, management is then free to divide the resulting EVA profit by whatever indicator is most useful and intuitively appealing to help line teams better manage it. A growing number of CFOs are coming to the realization that instead of thinking in terms of RONA and net assets and the DuPont ROI formula, it is easier and more effective to think of EVA as sales times the EVA Margin (EVA/sales), and to think about increasing EVA by looking for ways to increase the EVA Margin and to drive profitable sales growth at a positive EVA Margin—a goal that ultimately leads to EVA Momentum, which supersedes even the EVA Margin as a ratio measure of total performance progress from all sources.

ΔEVA is the change in EVA, and the best money measure of performance progress over a period. EVA increases when costs are intelligently cut, with all growth over the cost of capital, and when nonproductive capital is purged and assets turn faster (and also when management adopts a lower-cost capital structure). It decreases when non-value-adding costs are incurred, when capital is frittered away on nonproductive uses, and when management pursues growth that fails to generate an adequate return on the invested capital.

The change in EVA ignores history and registers all value-adding activity at the margin. It is independent of how much capital a company has invested in its past, and independent of legacy assets or liabilities it has inherited. It measures performance progress, whether for a firm that is turning around and making a negative EVA less negative, or for a profitable firm that is scaling, innovating, investing, growing, and adding to its economic profit.

EVA Momentum is the change in EVA divided by prior-period revenues. It is the size-adjusted growth rate in economic profit. It is the ideal overall summary measure of performance progress. It is the only business performance ratio indicator where bigger is always better, because it gets bigger when EVA does, and thus it can serve as every company’s most important financial goal. It is a statistic that can be used to grade overall performance, benchmark with peers, and set targets.

For reference, the median EVA Momentum generated among the Russell 3000 companies has averaged just 0.2 percent (at the margin, EVA growth is hard to come by); the 75th percentile firm generated a sustained average momentum (over five years) of 1 to 1.5 percent, and the 90th percentile firm generated 3 to 4 percent.

It is an applicable measure regardless of inherited assets or legacy liabilities, which also makes it an early indicator of turning points—of performance turnarounds in the making or of fatiguing business models. It is thus an ideal performance measure to span individual divisions in a company and put them on a common scorecard.

It is the only performance ratio with a clear dividing line between good and bad performance. That line is zero EVA Momentum. If EVA Momentum is positive, EVA has increased; if it is negative, EVA has declined.

EVA Momentum is also the single best statistic to quantify the quality and value of a forward plan. Briefly, the bigger the EVA Momentum over the plan, the greater is the NPV, MVA, and share price implied by the plan. More EVA Momentum is more EVA and is a greater discounted net present value, by definition. It’s the perfect proxy for CFOs to summarize and grade planned performance across even very disparate lines of business.

EVA Momentum can also help management improve performance and maximize forward-plan value, because it can be taken apart and eventually traced to all underlying performance and value drivers, but initially starting with these two: (1) productivity gains, as measured by expansion in the EVA Margin, and (2) profitable growth, as indicated by the product of sales growth and the EVA Margin.

EVA Momentum, in short, provides both a reliable and an encompassing single statistic to quantify performance progress in all relevant, value-adding dimensions, and it provides a window into all the moving parts that move EVA and drive shareholder value. It is the bird’s-eye view and boots-on-the-ground view at one fell swoop. It is the best of both worlds.

Productivity gains are measured by the change in EVA Margin. Even a firm that does not increase sales can increase EVA and generate EVA Momentum with an increase in its EVA/sales margin—from leveraging the 3-P’s, as we call it—price, product, and process—from earning and exerting price power; from fielding an outstanding, EVA-oriented product portfolio; and from enhancing process excellence spanning income efficiency and asset management—all of which are measured right through the EVA Margin schedule.

The overall change in the EVA Margin over a period thus succinctly and accurately summarizes the total net benefit of achievements in all the individual performance elements that appear on the EVA Margin schedule (which besides the EBITDAR and productive capital elements also include the benefit of managing and deferring taxes, restructuring the business, exhibiting acquisition discipline, and integration prowess, to name a few).

Profitable growth is the product of sales growth and the EVA Margin. It is the second fundamental way to increase EVA and drive EVA Momentum, by growing sales at positive EVA Margins, or by reducing sales where the EVA Margin is negative—it works both ways because this factor is the multiplicative product of sales growth and EVA Margin. For example, 10 percent sales growth at a 2 percent after-tax EVA Margin contributes 0.2 percent to EVA Momentum. The implication is that abundant sales growth at a low EVA Margin is inconsequential, but that even modest sales growth at a large EVA Margin can make a sizable contribution to EVA and to added market value. While ultimately it is the overall growth rate in EVA—the EVA Momentum—that determines MVA and franchise value, EVA Margin is a key lever on both sides of the EVA Momentum story (in productivity gains and in profitable growth).

The main insight here is that EVA Momentum explicitly includes the value added from achieving profitable growth, which of course is a critical performance dimension, and it conveniently expresses that value add on the exact same scale as the business model productivity gains. Momentum uniquely enables businesses to directly compare the two and make sensible trade-offs as required—such as possibly to forfeit a portion of the EVA Margin in exchange for even more profitable growth. And yet, and in contrast, measures like RONA and operating margin totally ignore the value of growth. They fight the business battle with one eye closed.

It is quite possible therefore that even experienced business managers do not fully appreciate how much value their profitable business lines are adding, because profitable divisions that achieve even modest sales growth can be the key drivers of the corporate EVA Momentum, even if they are not increasing their returns or their margins. In fact, the profitable divisions could well be adding significant EVA and creating material value even as their margins and returns diminish somewhat, due to the added value of incremental growth over the cost of capital. EVA Momentum and its component drivers can thus make for better insights into total value-adding performance, and thereby lead managers to make better planning and resource allocation decisions than they would by looking at other less effective, less complete, less correct indicators.

Market value is the value of the firm’s debt and equity capital, given its share price, net of excess cash, and assuming that the book value of liabilities approximates their market value. The debt capital consists of all interest-bearing short- and long-term debt and capital leases, the estimated present value of rents (from capitalizing operating rents at a multiple), and the postretirement net balance sheet funding liability (net of prepaid postretirement assets and accumulated other comprehensive income [AOCI], and net of tax).

Capital is the sum of all debt and equity capital, net of excess cash and after corrective accounting adjustments. Because balance sheets balance, it is also equal to the firm’s net business assets—the sum of its working capital (leaving out excess cash); net property, plant, and equipment (PP&E); investments; intangibles; goodwill; and other operating assets, again as adjusted for removal of accounting distortions.

MVA (market value added) is the firm’s market value less its capital. MVA is triply significant.

First, it measures the firm’s franchise value—its market value as a going concern above putting its assets in a pile, and which is due to all of its distinctive and proprietary assets and capabilities.

MVA also measures the owners’ aggregate wealth as of a point in time; it compares the present value of the cash that the owners can expect to take out of the business—if only by selling the shares and cashing out the loans—with the total cash they have invested in the business.

Last, MVA is the market’s implied estimate of the aggregate net present value of all of the firm’s capital investment projects—those in place plus those expected to materialize down the road.

MVA, in sum, shows, as no other measure can show, how successful management has been at allocating, managing, and redeploying scarce resources in order to maximize the net present value of the enterprise and thus maximize the wealth of the owners. Increasing MVA, even if only to make a negative MVA less negative, is the real test of corporate success over an interval of time.

Here’s the key insight: In principle, a firm’s MVA at a point in time is equal to the present value of all the EVA profit it can be expected to earn over its entire future life. Firms that just cover the cost of capital and break even on EVA tend to sell close to book value and to trade for no MVA premium. Only firms that can earn and sustain EVA profit will create a distinct franchise value and reward their owners with added wealth. And thus increasing EVA is the key to creating wealth, to adding more to a firm’s market value than the firm invests in its capital till.

An implication is perhaps startling: Corporate managers should dispense with discounted cash flow analysis, and should instead project, analyze, and discount EVA to measure and improve the net present value of plans, projects, and acquisitions. The NPV value is the same for a given forecast, whether from discounted cash flow or from discounting EVA, but the EVA method provides more ready insights into the full range of value drivers and key assumptions, and, unlike cash flow, it can be used to measure actual performance and strengthen accountability for generating results that add to shareholder value.

CVA (current value added) is the value from capitalizing the firm’s current EVA in perpetuity. It is the MVA, or franchise value, that the company would have if the firm was simply able to sustain its most recent EVA forever and was incapable of growing it any further. It is measured by taking the trailing EVA and dividing it by the cost of capital, which is the formula to determine the present value of a level payment that recurs year after year, ad infinitum (adjustments are also made for midyear discounting and using average capital in the computation of the capital charge).

FVA (future value added) is the present value of the projected growth in EVA over the prevailing level. The market’s estimate for FVA is derived simply by subtracting CVA from MVA—from removing the portion of MVA that is due to capitalizing the current EVA in perpetuity. The larger the FVA remainder, the more the market is registering confidence that management has positioned the company for sustained growth in EVA (and vice versa). The relative degree of confidence is expressed in the Future Growth Reliance (FGR) ratio, which is the percentage of the firm’s aggregate market value that is in the hands of FVA—of expectations for future growth in EVA—and also, indirectly, in the Market-Implied Momentum (MIM)—the EVA growth rate that is implicitly baked into the share price.

MVA Spread is the ratio of MVA to capital. It measures the efficiency with which investors’ capital investment has translated into a franchise value and into an aggregate net present value premium. An MVA Spread of 50 percent indicates that every $1.00 of invested capital has turned into $0.50 in added wealth. Looked at another way, the ratio quantifies a risk cushion, the market value premium percentage to invested capital that will fend off an erosion in the investor’s principal investment due to an unforeseen drop in the firm’s EVA earning power.

NPV Spread is the ratio of NPV to PV of projected capital investment. It is computed by measuring the present value (PV) of the EVA profit that is forecast for a decision or investment, which measures its NPV, and dividing that by the present value of the capital invested in the decision or project year by year. The larger it is, the more risk cushion there is. It is the recommended alternative to internal rate of return (IRR), which erroneously assumes all intermediate cash flows can be invested at the IRR, which is incorrect. Beware, though, it is not the measure to maximize—EVA and NPV are. It is a measure to consider the risk and fit the project into a risk budget. For instance, some firms establish minimum NPV spreads for projects in various risk classes as a risk control mechanism.

MVA Margin is the ratio of MVA to sales. It measures how efficiently and prodigiously sales translate into franchise value. As a mathematical insight, just as MVA is in principle the present value of projected EVA, which divides into CVA and FVA, a firm’s MVA/sales ratio should equal its current EVA Margin plus the present value of its projected EVA Momentum, divided by the cost of capital. It is the capitalized value of profitability and profitable growth.

Future Growth Reliance (FGR) is the ratio of FVA to market value. It is the percent proportion of the firm’s market value that is derived from, and depends on, growth in EVA. The greater the reliance, the more confidence the market is placing on the company’s ability to rebound from a cyclical downturn or strategically drive EVA expansion.

Market-Implied Momentum (MIM) is EVA profit growth rate that is impounded into the company’s stock price or, more specifically, that is reflected in its FVA, the portion of overall market value that is attributable to the present value of expected EVA growth.

MIM is a more reliable indicator of consensus market expectations than the so-called consensus earnings per share (EPS), which is, after all, not a true consensus, but is an opinion survey of sell-side analysts, ignoring the buy side, for EPS, a measure that hardly tells the whole value story. MIM, by contrast, literally discounts to the share price, and as such, it represents the market’s true outlook for the firm given the information that investors have collectively factored into its share value.

CFOs use their MIMs to understand and monitor market expectations, to set a bogey for judging the company’s actual EVA Momentum, and to help them set minimum plan and compensation performance targets in terms of EVA growth goals.

Market-implied EVA improvement is the annual EVA buildup that cumulates over 10 years and discounts back to the current share price—technically, to FVA (the portion of the firm’s value that implicitly derives from expected growth in EVA). To determine it, the indicated MIM rate is multiplied times current period sales, which converts the expected growth rate into a money measure of expected EVA improvement. Multiply that by 5 to estimate the five-year forward-plan EVA improvement goal the company must achieve to be on track with market performance expectations.

Free cash flow (FCF) is NOPAT less the period change in capital—it is the cash generated by the business that is free of, or net of, all the capital invested in net business assets. It is total cash operating receipts minus total cash operating disbursements, no matter whether the disbursements were recorded as expenses that reduced NOPAT or as expenditures that added to balance sheet capital. It is the net distributable cash flow generated by, or required by, the business, and as such, it is by definition also equal to all cash transactions with all providers of capital to the company.

A company that generates more NOPAT than it reinvests in capital expansion generates positive FCF to pay interest on its debts, to retire debt, pay dividends, buy back stock, or accumulate a war chest of cash that permits more of the same down the road. A company that invests more in growth capital than it earns through its NOPAT winds up with a negative FCF that must be financed by raising new debt or equity or by drawing down surplus cash. Moreover, any cash it pays out in interest or dividends or share buybacks cannot really be paid; those outlays only add to the cash deficit that must be financed.

As a consequence, and by definition, discounting a projection for FCF to a present value determines the aggregate market value of the firm’s outstanding debt and equity securities, for it discounts the anticipated cash transactions to and from the investors over the life of the business at the appropriate blended cost of capital rate.

Yet ironically, FCF in any one year, or even over longer intervals, is not a reliable of measure of performance. That’s because, as long as a company is investing in positive NPV projects and strategies with attractive returns above the cost of capital, the more investments it makes, and the lower or more negative its free cash flow goes, the greater its NPV, MVA, and stock price will be. It is simply not possible to tell whether a firm is more or less valuable by generating more or less free cash over a period of time.

That’s not just a theory. It is a stock market fact. The evidence proves it (furnished upon request). Bottom line: FCF measures the magnitude of cash liquidity or funding deficit over a period—it is a treasury measure—but it is most decidedly not a performance measure. And this applies to all cash flow measures, however defined.

The conclusion: Cash is not king. EVA is king. Management should always aim to maximize the present value of EVA and the firm’s franchise value and owner’s wealth, and just let the cash flow chips fall where they may. At least that is the ideal.

Companies that are genuinely cash constrained, like private companies, should still use EVA, but just measure it using a higher cost of capital than for a pubic, liquid firm. That will sweat more cash out of the balance sheet, and cut off projects that would otherwise get done, in order to force a balance between available cash and cash investment opportunities.

FCF generation is the ratio of FCF to capital. It is the rate at which the firm generates or consumes cash in its business activities, net of all investment spending, expressed as a yield on (average) capital. It is mathematically equivalent to the return on capital (NOPAT/average capital) less the growth rate in capital (call that GCap, and it equals ΔCapital/average capital); that is, FCF generation by definition equals ROC – GCap.

For example, a firm that earned an ROC of 15 percent and invested in capital at a GCap growth rate of 10 percent has an FCF generation rate of +5 percent. It is generating a positive net distributable cash yield on its capital. In sum, where ROC > Gcap, FCF generation is positive, and the company is internally cash sufficient and generates more than enough profit to fund growth. And if ROC < GCap, FCF is negative and external funding must be sought (or cash reserves taken down).

FCF generation is a measure of net cash liquidity and funding need, but like FCF, it is not a measure of performance. It is a measure of liquidity generation or net funding need only.

EVA Margin schedule is a special format to compute the EVA Margin and connect it to all the underlying productivity indicators that are familiar to managers and that they can manage. It puts all pluses and minuses of business productivity performance on a common margin scale, which is a tremendous simplification that enables line teams to more easily spot trends, make decisions involving trade-offs, and prioritize initiatives in terms of added value.

EBITDA Margin is the ratio of EBITDA to sales. It is the classic earnings before interest, taxes, depreciation, and amortization cash profit measure, as a percentage of sales.

To be clear, though, as reported by EVA Dimensions, it is measured net of stock-based compensation, for two reasons. One, stock-based compensation is a necessary and unavoidable cost of keeping key people motivated and aligned with creating value. Second, the stock-based compensation charge recognized on financial statements is a legitimate estimate of the expected ongoing cost to the shareholders of diverting a portion of corporate value creation to employees. Though not cash, stock-based compensation is an unavoidable cost of doing business. It is as if the employees were paid in cash, and they returned the cash to buy options in the firm. It is a self-financing expense, but an expense nevertheless that reduces the present value of the company.

EBITDAR add-backs are all the adjustments to convert EBITDA to EBITDAR—which is an even cleaner, purer, more comparable measure of cash operating profit.

One add-back is for rent expense, because rent expense is effectively just depreciation and interest paid via a third party. Adding back rent expense makes EBITDAR the same whether an asset is leased or it is owned, whereas EBITDA is always greater if an asset is owned rather than leased. EBITDAR is thus impervious to shifts in the mix of owning or leasing assets.

The other add-backs are for: (1) R&D and advertising spending, which are added back in order to isolate the underlying operating profit before discretionary investments in intangible assets (which under EVA are capitalized and amortized as part of the intangible capital charges farther down the EVA Margin schedule); (2) reported retirement expense less the service cost (service cost is the actuarial increase in the present value of future retirement payments that the firm owes its employees due to service in the period, which better approximates the ongoing expected cost than the reported cost, which is based on numerous questionable assumptions and mixes in irrelevant sunk costs from prior periods); and (3) the changes in bookkeeping reserves for bad debts, LIFO, warranty expense, and so forth (to bring recurring cash flows from operations into the EBITDAR picture instead of stuffing them into balance sheet accounts that can be manipulated).

EBITDAR is EBITDA plus EBITDAR add-backs—it is an improved version of EBITDA that is a better, purer, more comparable measure of true cash operating profit. EBITDAR is more reliable than EBITDA for judging a business’s pricing power and operating efficiency.

Productive capital charges is the sum of all depreciation, amortization, and pretax cost of capital charges on the firm’s productive capital—its working capital, PP&E, and intangible capital, both bought and built (R&D and ad spend are capitalized under EVA), but excluding goodwill (which is handled down the schedule as a corporate charge).

The pretax cost of capital—which is a grossed-up version of the familiar after-tax cost of capital—is used to measure it so that the charge is directly comparable with any other operating cost, like cost of goods sold, that is also pretax (a firm that has a weighted average cost of capital of 6 percent after tax and a 40 percent tax rate, for example, is charged at a 10 percent pretax cost of capital rate). An improvement in asset management thus appears quite simply as a reduction in the rental charge and an improvement in the margin, just as if prices had increased or operating costs had been lowered.

The more productive capital a company employs in relation to its sales, and the greater the capital charge rate, the larger its EBITDAR margin must be before economic profit can be created. The productive capital rental charge thus serves as the equivalent of a threshold EBITDAR margin—it is the cash operating profit margin minimum required to earn the cost of capital and generate EVA.

The productive capital charge can be depicted in two ways. First, it is the sum of three component charges—a percent margin charge for working capital; for the PP&E assets owned and rented; and for the intangibles, bought and built, excepting goodwill (the goodwill charge is shown even farther down the EVA Margin schedule, in a separate section). Second, it can also be computed by multiplying productive capital intensity—how much productive capital is being employed per dollar of sales—times the productive capital rental rate—the weighted average rate at which the productive capital is depreciating or amortizing and is incurring cost of capital charges. The two views of the productive capital rental charge enable management to follow trends, benchmark with peers, and isolate underlying competencies and gaps that may need attention.

Productive capital intensity is the ratio of productive capital to sales. A higher ratio indicates the firm is tying up more capital in revenue-generating assets to produce each sales dollar it generates—that the business is more capital intensive. There is no evidence to show that companies with lower capital intensity as a general rule earn more EVA, however. Capital-intensive firms like petroleum giant Exxon Mobil, or even Google with its massive investments in systems, servers, and R&D, manage to do very well on EVA because they are able to generate massive EBITDAR margins. Yet it also is true that, everything else held equal, doing more with less and leveraging investments in productive capital assets into even more sales, customer satisfaction, and EBITDAR Margin can be key differentiating factors. Apple, for instance, manages to have a better brand, higher customer affinity, price power, and innovation prowess than other tech companies while still running an extremely lean capital ship, as evidenced by its productive capital-to-sales ratio. A stronger supply chain, better product mix, and higher yields on intangibles do matter, of course, at least relative to peers and in light of the company’s business model, and are summarized in this statistic.

Productive capital rental charge is the ratio of the productive capital charges to productive capital—it is the consolidated average rental rate applied to the firm’s productive capital. It is the weighted average rate at which the productive assets are depreciating and amortizing, bearing interest at the pretax cost of capital, and turning into a charge against EVA. Risky firms must pay a higher rental rate to compensate for the risk. Firms using fast-depreciating assets—for instance, a firm like Google that has considerable capital tied up in rapidly obsolescing servers—must pay a higher rate (whereas regulated utilities that invest in long-lived generation assets pay a lower rate to rent their assets and recover their capital). And firms that invest a large proportion of their capital in intangibles, like for R&D and ad spend that tend to obsolesce rapidly and are swiftly amortized, will generally pay a higher average rental rate for their mix of productive capital assets.

EVA Margin Before Tax is the EBITDAR margin less the productive capital charges, as a percentage of sales. It is a key productivity measure that combines income efficiency and asset management, and that neutralizes business model differences. It is suitable for measuring line teams and division heads, as it comes before corporate charges are deducted.

Corporate charges are the sum of taxes computed the EVA way, less Other EVA, plus the cost of capital on unimpaired goodwill and on accumulated restructuring charges. It is the net frictional drag that separates bottom-line EVA from pretax EVA.

EVA tax is computed at an assumed smoothed, standard tax rate, less the cost of capital saved by the net deferral of tax, including taxes deferred compared to the assumed smoothed rate.

Other EVA is a grab bag of sundry income and expense, credit and charge items that are unrelated to sales and direct business operations. It consists of non-sales-related operating income, after tax, plus the EVA from investments carried at cost and at equity, less the EVA attributable to noncontrolling interests, less the cost of capital on miscellaneous noncore assets, plus the cost of capital saved by using noncapital, non-interest-bearing liabilities as funding sources, less the cost of the capital required to close a net unfunded retirement funding loss or gap.

Capital charge on cumulative special items after tax is the cost of capital associated with the accumulated balance of unusual and nonrecurring charges. EVA isolates ongoing operating performance by removing unusual and nonrecurring charges from the firm’s NOPAT earnings, but to preserve the integrity of double-entry bookkeeping, the charges are also added back to balance sheet capital, which turns into a capital charge to EVA as a percentage of sales.

In this way a restructuring does not lead to a jarring period expense, but is rather viewed as an investment that can (and should) increase EVA by increasing the firm’s NOPAT profit by more that the cost of the capital invested in the restructuring.

Asset impairments (other than goodwill, which are added back to goodwill directly) are also added back to capital and included in the capital charge to the EVA Margin. Under EVA, an impaired asset just stays on the books. It continues to impair EVA with a capital charge in future just as it has in the past, and to serve as a constant reminder that capital has been misallocated. An impairment, as a pure bookkeeping write-down of no economic substance, thus has no net bottom-line impact on EVA as a pure accounting matter.

Losses on asset sales are also added back to earnings, and added back to this capital account. In other words, under EVA, capital is reduced by after-tax sale proceeds, by the net after-tax cash amount recovered in a sale or in liquidation, and not by the meaningless book value of the disposed assets. Consequently, if management sells assets for more than the EVA they are contributing to the firm, then the firm’s EVA will increase with this accounting treatment, even as a bookkeeping loss is registered.

Gains are treated symmetrically, and are applied to reduce capital, after tax. Rather than showing a one-time unsustainable earnings hike, a gain on sale is thus converted into an ongoing reduction in capital and in capital charge, thus effectively replacing the earnings lost from the sale of the asset.

The costs of contingencies, legal settlements, and acquisition integration are also removed from earnings and added into this capital account as permanent investments in the organization to maintain its existence and organizational vitality.

All of these adjustments smooth EVA in the period in which they occur and thus enable management to demonstrate the real merits of the decisions, but in subsequent periods they have no effect on the firm’s ability to increase its EVA and hence to generate EVA Momentum.