CHAPTER 3
Accounting for Value
It is now time to have a little fun ribbing the accountants. One of my all-time favorite New Yorker cartoons—and this goes back to when Enron and WorldCom and a bunch of others were blowing up in a wave of accounting shenanigans—featured two comely misses at a bar, glancing over at two gentlemen, and one whispers to the other: “He has an air of danger about him. He’s an accountant.” Truer words were never spoken. Accounting is dangerous. But not for the reasons everyone assumes.
The real danger is not in the few fraudulent bad apples that make the headlines. It is in the great bulk of companies that hew honorably to generally accepted accounting rules. The danger stems from the fact that mandated accounting rules are flagrantly at odds with economic reality, distort performance measurement in a whole bunch of ways, and make valid comparisons across companies or business units virtually impossible. The real question for the thoughtful CFO—after complying with the law of the land, of course—is not whether to stick with the required accounting, but how to repair it. Aside from deducting the full cost of capital (COC), which is just essential, how else can reported accounting profits be modified (we are not about to throw out the whole system) so that EVA becomes an even more accurate barometer of value and a more effective guide to making better business decisions?
Before we get to the solutions, let me expose one incredible accounting defect that will show you that the emperor has no clothes. A fundamental reason accounting is so flawed as a management and shareholder valuation tool is that accounting statements cater to lenders rather than owners. Lenders want to get repaid even in the worst of circumstances, when the business has failed and it is a question of liquidating what’s left of the carcass. Accounting rules create balance sheets that are intended for exactly those dire circumstances—to show the value that might be realized in a salvage sale.
But if we remove ourselves from the depressing company of Scrooge and Marley (the creditor class) and join the scintillating society of shareholders (the owner/proprietor class), the balance sheet changes before our eyes. As shareholders and as corporate managers, we are chiefly concerned with the company’s performance and its value as a going-concern business enterprise. And from that perspective, we never expect to fully liquidate the assets. We need them to run our business—which means, strange as it may seem, that so-called assets aren’t really assets at all. They are liabilities.
Assets tie up capital that must be financed at the cost of capital. A firm that ties up more assets on its balance sheet is perhaps more bankable—there’s a greater reserve of blubber to cushion a fall—but as a business enterprise it is less valuable than a leaner outfit that earns the same profit with fewer assets. All else being equal, fewer assets mean more EVA, more real franchise value, and more wealth to the owners. Hence, accounting assets are actually liabilities. You want less of them, not more. The only true asset any company has is its ability to earn and increase EVA, which never appears on a balance sheet. If accountants have gotten even the most basic definition of an asset wrong, imagine how many other mistakes they’ve made. Take a deep breathe. It’s a long list. Let’s talk through a few of them now.
MIXING OPERATING AND FINANCING DECISIONS
Another incredibly basic mistake accountants make is commingling the effects of financing decisions and business decisions, so that a business decision can appear good when it really isn’t (or look bad when it really is good). For example, any investment financed with debt, such as a major acquisition, will contribute to accounting net income, increase earnings per share (EPS), and elevate the firm’s reported return on equity (ROE) so long as it generates a rate of return that is anything over the after-tax cost of the borrowed funds—which these days could be 3 percent or even lower. A return on investment that low is hardly acceptable. The firm’s stock price clearly will not be lifted until a much higher return standard has been met.
How is it, though, that the firm’s stock price won’t increase if its earnings per share do? If EPS goes up, then why doesn’t the stock price go up, of necessity? Because debt-financed growth comes at a hidden cost. Adding leverage adds variability to the company’s earnings. As more fixed interest payments are deducted from uncertain operating profits, the company’s earnings and stock price become more volatile. They end up fluctuating more widely over the business cycle than if equity had been used to finance the growth or if equity was at least part of the financing mix. Confronted with the added financial risk, shareholders will understandably demand a higher return. Put simply, part of the hidden cost of adding debt is that it raises the cost of equity.
To earn a higher return to compensate for the added financial risk, shareholders will discount the firm’s EPS at a higher rate and thus they will pay a lower multiple of the earnings. The P/E going down offsets the EPS going up. The bottom line is that an increase in EPS that arises from a temporary increase in leverage is not apt to increase the share price.
A permanent change in the debt-equity mix is another matter. A shift to a permanently higher leverage ratio, but one that is still within prudent limits, can reduce the overall cost of capital and increase the stock price, but not because EPS will go up. It’s the tax subsidy that counts. Tax laws generally allow interest payments on debt, but not dividends, to be deducted from taxable income. Raise debt and retire equity, and keep it there, and the present value of the taxes saved by swapping debt for equity adds to the value of the company. Said differently, it is the equivalent of reducing the weighted average cost of capital. All the tax savings—and hence the value created by it—flow to shareholders as the claimants on all residual income.
One of my clients, Equifax, took advantage of this. Shortly after adopting EVA, the CFO at the time, Derek Smith, decided to permanently increase the firm’s leverage ratio as a means of reducing the cost of capital. This was a firm that enjoyed a very strong cash flow, had paid continuing and increasing dividends since the 1920s, and had very little debt on its books because, first, it didn’t need the money (growth was self-financing with internally generated cash) and, second, it was countercultural. Here was a company whose business was to rate credit now volunteering to reduce its own credit rating.
A confusion that trips up many a CFO is that when debt is raised to retire equity, the debt becomes riskier and more expensive (with a lower credit rating), and the equity does, too, as I have argued. How can it therefore ever be sensible to raise both the cost of borrowed money and the cost of the equity by raising the leverage target? The answer to the puzzle is that the weights are changing. There is more debt and less equity in the capital structure. While the cost of each rises as more debt comes into the picture, more weight is placed on the lower-cost debt than on the higher-cost equity, so that the weighted average cost comes down. This is entirely because corporate income taxes are saved.
It can be a trick to explain this to boards, but we did, and Equifax’s directors approved the new higher leverage policy. But as Derek Smith rightly noted, nobody would believe the new policy was real unless it was put in place right away. So we fashioned an up-front and ongoing stock buyback program. The company announced the new higher leverage target, increased its debt to the target ratio, and used the proceeds to buy back a large block of stock. But more than that, management told investors that in subsequent years it would borrow even more money—that as it added to capital and continued to expand, it would continue to borrow money it did not really need and use it to buy back more stock in order to maintain the capital structure goal.
When and how did Equifax’s stock price react? As soon as Equifax announced the new policy, the price increased 25 percent. The price jumped because the new policy was carefully explained, and the stock buyback made it credible. But note that the stock price increased not because of the buyback, but because of the new, lower-cost capital structure.
In fact, returning cash to investors in any form cannot really be of value, because the investors already own the company and own any cash it could distribute. It is like going to your bank, and taking cash out of your account, and asking, am I wealthier? You are more liquid, but you are not wealthier. The cash you have in your hand is cash you no longer have in the bank. You have changed the form but not the amount of your wealth. Likewise, Equifax shareholders obtained cash from the buyback, but the company had to borrow to pay it to them, and the debt would have to be repaid with priority out of cash flow that could otherwise have been paid to the shareholders down the road. It is always how a share repurchase is financed, and not the repurchasing of shares, that adds value. Consider another example. If management distributes surplus cash that the market fears would be used for high-priced acquisitions or other sub-EVA investments, the share price may rise, but again, the increase is all due to how the distribution is being financed, which in this case came from releasing capital that would otherwise be imprisoned in negative net present value (NPV) investments. Distributing cash is by itself always value neutral. You’ve got to go deeper, to the source of the distribution, to determine any impact on value.
MVA tells us that, too. A stock’s market value goes down once the stock goes ex-dividend, and the book value of the equity goes down as the dividend is deducted from retained earnings. Market value and capital decline in equal and offsetting amounts, so there is no net effect on MVA, which is as it should be. If there is no effect on EVA, then there should be no effect on MVA. Paying out the fruits of our efforts, or even borrowing to prepay the fruits of our efforts, does not yield more fruit in and of itself. That is the truth that EVA and MVA see, but that other measures mangle horribly.
All this may sound like double-talk. If so, read it again. And remember, it is easy to be misled by EPS and return on equity (ROE) and accounting metrics that mix operating and financing decisions. Those measures do not discriminate between temporary and permanent changes in debt financing and debt policy. But the difference is crucial. And even with a permanent increase in leverage, a great portion of the increase in EPS and ROE is needed just to compensate for the added risk and does not add to the share price.
How does EVA circumvent this? EVA is measured using a blended cost of debt and equity capital where the weights are not the actual proportions outstanding in any quarter or year, and where the full cost of the leverage ratio is reflected in the cost of the equity that is assumed. Ideally, the blend represents the target proportions management will employ on average over time. In our work we approximate that by using a running three-year average debt-to-equity ratio, but guidance from management would be most welcome by the market. The point here is that a transitory debt-financed stock buyback or debt-financed acquisition won’t really move the EVA cost-of-capital needle, even though those maneuvers will temporarily and misleadingly spring load EPS and ROE.
DISCHARGE SURPLUS CASH
Another financing distortion comes from hoarding excess cash. Many successful companies, Apple and Microsoft among them, have accumulated vast cash reserves and invested them for pitifully low returns that mask how really profitable the underlying businesses are. Under EVA, excess cash is assumed to be invested in marketable securities bought at market prices that yield the return the market expects for the risk. The investments generate zero EVA, by definition. If the risk is low, the return will be low, but it is zero EVA nonetheless. In other words, this is a side game that really has nothing to do with the performance of the underlying business.
Accordingly, excess cash is removed from capital and the associated investment income taken out of net operating profit after taxes (NOPAT), so that the EVA measured is the EVA of the business. As a result, when a company with a cash hoard makes a massive cash payout as a dividend or share buyback, nothing happens to its EVA. It’s a nonevent. In contrast, EPS and ROE go haywire, another example of how they confusingly mix operating and financing decisions and add a lot of noise to the business performance signal.
Incidentally, to be consistent, excess cash is also removed from market value as we measure it, so that when a firm pays out excess cash, nothing happens to the market value or to the capital we measure, so nothing happens to MVA, either. Wealth cannot be created or destroyed by transferring it from the left hand to the right hand. This is again as it should be. There is no change in EVA, and thus there should be no change in MVA, when excess cash is simply transferred from corporate coffers to investors’ pockets.
TREAT LEASED ASSETS AS OWNED
Long before the International Financial Reporting Standards (IFRS) accounting rules came along or it became at all fashionable, EVA has treated leased assets as if they were owned. This is another facet of separating operating performance from financing decisions.
To make the adjustment, the present value of rented assets is estimated as a multiple of the rent expense. It is included in debt capital in the cost-of-capital calculation, and it is added to net property, plant, and equipment to become part of the net business-asset capital base that the operating team is responsible for managing.
NOPAT is also adjusted as if the rented assets were owned. The interest component of the rent expense is added back to NOPAT, but the depreciation part stays on as a deduction. Furthermore, the capital charge includes the cost of capital applied to the present value of the rents.
When the dust settles, EVA is computed as if the rented assets were owned. EVA is burdened with the depreciation and weighted average cost of capital on the rented assets. The idea is that managers should allocate and manage assets—and be judged on asset management performance—the same way no matter how the assets have been financed. The objective also is to make EVA into a purer, better, more comparable measure of profit performance that is insulated from differences in the mix of owning or leasing assets that occur over time and from company to company.
REVERSE IMPAIRMENT CHARGES
Accountants are having a lot of fun these days valuing and revaluing the book value of assets—which, as I have pointed out, is not the point at all, because assets are really liabilities. Why revalue a plant asset when other than in liquidation, value is never in the plant, but in the EVA the plant earns?
Nevertheless, the bookkeepers are required to follow the rules and determine whether an asset is being carried at more than its fair value, and if so, to write down the value. The value is never written up, of course, because the accountants are in bed with bankers who only care about the dark, depressing side of life. The euphemism for the write-down is an impairment charge. Just understand, it is a pure bookkeeping entry and has no effect on cash flow, and thus it has no effect on value. But after the write-down, a company can all of a sudden look a lot more profitable than it really is, especially on measures like the rate of return on the now-depleted equity. It’s like playing golf and taking lots of mulligans. Anyone can beat par if you ignore a lot of the wild swings that didn’t pan out.
EVA puts the mulligans back on the scorecard. It reverses the impairment charge. The charge is removed from earnings and added back to balance sheet capital, as if the charge had never happened. It is a nonevent in the EVA world because accounting is not reality, and nothing actually happened.
What if a company really did overpay for an acquisition and the goodwill it has recorded on the books is not really worth it? Shouldn’t the company take an impairment charge and write it down? My answer is still no. Leave it to EVA. In this case the company will be unable to earn the NOPAT needed to cover the cost of the acquisition capital it paid, and its EVA will be impaired. EVA will register the loss in value, not some accounting adjustment to balance sheet assets. We do not want the accountants to do the job of EVA and the security analyst.
A simple example may help. Suppose management buys a widget-making machine for $1,000 and expects to use it to generate a NOPAT of $150 (sound familiar?—it’s SSCo, writ small). At a 10 percent cost of capital, the machine generates $50 in EVA and adds $500 to the net present value of the company. The company’s book capital understates market value, but that never bothers the accountants. They don’t write up the value of assets (and I am certainly not saying they should). What bothers the pencil pushers is what happens next.
Let’s assume the very next day the price of widgets falls permanently, and the same machine is able to produce only $80 of NOPAT. Now EVA is −$20. The present value of EVA is a loss of $200, which means that the market value is only $800. It is the $1,000 book capital minus the $200 EVA valuation discount. EVA registers the profit loss, and the present value of EVA measures the impairment of value. There is no need for accountants to intervene here at all. But they do. International Accounting Standard No. 36 (IAS 36) mandates that they step in to write down the asset to its recoverable market value, and let’s say that is $800. Now what would EVA show? Going forward, with NOPAT of $80, EVA would show up as $0 on an $800 book capital, and MVA would be $0, according to the accounting. But that is hardly useful or factual.
Impairment charges were not needed for the market or management to get the information that value had been lost. The decline and fall of EVA tells that plainly enough. Moreover, reducing the book value to market value is not helpful. It erases the memory of how we got to where we are. It misleadingly improves EVA from −$20 to $0. It reports MVA, the measure of wealth, as breaking even when the owners have actually lost $200. All these problems stem from accountants’ mistaken belief that the balance sheet should record market value when balance sheet assets are always just a cost of doing business.
I have also found a few investors who seem confused about this. In one memorable meeting with a man who runs a China fund, he saw a problem with using EVA for evaluating Chinese companies because of widespread fraud (who knew?). He mentioned as an example one Chinese company that had recorded considerable asset acquisitions in recent years. When he visited the factory, he saw that the assets were no good at all. With further probing, he discovered that the company had bought the equipment at inflated prices from the CEO’s son-in-law. My reaction was that all that meant was that the company had recorded a greater obligation on its balance sheet to earn a profit it cannot earn, which would make its EVA more negative and produce a greater MVA discount to be deducted from its book capital. In other words, it is exactly the same as the example I gave earlier. It would make no difference whether the widget-making asset lost value because the price of widgets went down or the widget machine was acquired for an inflated price to begin with. Either way, there is an impairment of value. And either way, it is manifest in EVA. Accountants, go away.
CAPITAL GAINS AND LOSSES GO TO THE CAPITAL ACCOUNT
Let’s consider a variation on the accountants’ impairment charge. What if an unrecognized loss in value is realized? What if an asset or business is sold and a book-value loss is recognized at the time of the sale? How is that treated in the EVA world?
Under EVA, an asset disposition loss is treated exactly the same as impairment accounting. The book loss is backed out of NOPAT and put back onto the balance sheet, but this takes a little more explanation.
Under standard accounting rules, a book-value loss on sale is charged against profit. That makes the decision to sell and exit always look bad, when it may be the best thing to do. The real news in the transaction may be that the asset is now worth more in the hands of another owner who is willing to pay a premium over what it is worth to the incumbent owner. It is also possible that the asset is being sold for too little. How can we tell the difference?
As with an impairment charge, a loss on a sale is reversed. The book loss is added back to reported earnings so that NOPAT measures the underlying ongoing earnings power of the business. But to be consistent, and to preserve the integrity of double-entry bookkeeping, the loss is also added back to balance sheet capital. In accounting terms, NOPAT is credited for the loss, and the capital account is debited in the same amount (I really am a frustrated accountant at heart). A special capital account is created for this purpose. We call it cumulative unusual losses after tax. It is a holding pen for all the one-time, nonrecurring write-downs and charges, and it, too, is subject to a capital charge.
Let’s take a simple example. In fact, let’s run through a make-believe analysis of Coca-Cola’s decision to replace its stainless steel containers with disposable cardboard ones. I am going to set this up by ignoring a loss on the sale of the steel containers at first, and then bring the loss into the picture.
Suppose that the decision to switch to cardboard would reduce NOPAT by $10 a year, because expensing the cardboard containers is more costly than continuing to incur the depreciation expense on the steel containers. But suppose that the steel containers can be sold for $150, which is taken out of capital. If the cost of capital (COC) is 10 percent, Coke’s owners would come out $5 a year better off making the switch, which is indicated by the increase in EVA:
EVA = NOPAT − COC × Capital
$5 = −$10 − 10% × −$150
Note that since the cost of capital is deducted from NOPAT, the reduction in capital arising from the sale of an asset adds to EVA. And it adds to EVA regardless of what Coke does with the sale proceeds, because the EVA model always assumes that the company reinvests the cash to just earn the cost of capital and break even on EVA. As for judging the wisdom of the move, the calculation shown is the complete story.
Assuming that the proceeds are invested at the cost of capital is more sensible than you may imagine because, if nothing else, Coke could use the sale proceeds to retire its debt and buy back its equity in capital structure proportions, and let its investors earn the cost of capital by reinvesting the proceeds in a stock and bond portfolio of similar risk. In this example, Coke’s investors could earn $15 a year on their own account by investing the $150 proceeds at the 10 percent cost of capital. Although accountants do not record that profit on Coke’s books, that profit would be every bit as real to them as any profit that is actually earned inside the firm. EVA, in short, makes managers into partners with the owners. The goal is to maximize the joint profit of the firm and the profit opportunity available to the firm’s owners with the capital outside of the firm. The bottom line in this example is, as long as Coke’s NOPAT falls by less than the $15 in profit that the owners could earn investing the capital outside the firm, the owners will be better off, on net. If NOPAT falls by $10, as the example assumes, then on net, the owners are better off by $5, which is what EVA shows. This is one of the real attractions of EVA—by charging a company for using capital, EVA correctly credits the company for releasing capital and letting the firm’s investors earn a return on it on their own. Measures like EPS and EBITDA are not even in the zip code of getting this right because they do not recognize the true opportunity cost of using or of releasing capital.
What if, to play the devil’s advocate, Coke actually reinvested the proceeds in another project instead of paying them out? Then the two decisions should be split and not commingled. One decision is to sell the steel and shift to cardboard and pay the proceeds out to the owners, and the second decision is to raise capital from the owners at the cost of capital and invest it back into the business. Each decision should stand or fall on its own EVA merits. The value of each should not depend on the value of the other, because capital can be presumed to flow to and from the investors at the cost-of-capital rate.
Now let’s bring a bookkeeping loss on sale into play. Suppose that all the facts are the same as before except for one thing. Suppose Coke’s accountants are carrying the stainless steel containers on Coke’s balance sheet at a $200 book value. This time, when the containers with a $200 book value are sold for $150 in after-tax proceeds, a $50 charge to earnings must be recorded. The question is: should recognizing the charge and reducing the book profit make any difference in the value of the decision?
Of course it makes no difference! It is just a bookkeeping entry. But let’s follow this through. If we take the accounting at face value and run the $50 loss through the earnings, then instead of NOPAT falling by just $10, NOPAT would fall by $60, and instead of capital falling by the $150 in cash proceeds, it would fall by the full $200 book value that the accountants have written off the balance sheet. The result: while EVA actually goes up by $5, the accounting has EVA going down by $40:
EVA = NOPAT − COC × Capital
−$40 = −$60 − 10% × −$200
This is clearly not what we want to see. EVA is intended to measure and motivate the right decisions, the ones that will maximize the company’s net present value and stock price. And in this case, selling the steel and switching to cardboard is the right thing to do, but the raw accounting shows EVA taking it on the chin. What gives?
This is a perfect example of another accounting distortion known as “successful efforts,” which means that only productive investments are admitted into the capital account, and unsuccessful ones are written off. In the accountants’ world, assets are admitted to their exclusive balance sheet club only when they meet high standards. But that is not the real world, and it is not the purpose of the balance sheet as far as managers and owners are concerned. Remember, value is to be found in EVA, not on the balance sheet. The balance sheet is a cost, not an asset.
In the real world, finding winning investments and strategies requires investing in losers now and again. If you are running a retail business, not every store succeeds. Some of them just end up in the wrong location and must be closed. Or say you are drilling for oil in what a geologist would call a one-in-five success ratio prospect—that says you would have to drill five wells to have a very good shot at finding one that pays. What is the cost to find one good well? The cost of drilling five wells. You cannot as a matter of policy and practice locate one well without drilling five, or so the probability tells us. Investing in dry hole losers is an unavoidable part of the investment required to discover the winners. And though accountants write them off, investments in dry holes and losing stores and technology flops (even Apple has had a long string of misses over the years) are actually quite valuable in a way. We know not to drill there again. We do not put a store like that there again. We do not change map apps in the midst of new phone launch. We learn from our mistakes, or should.
In our knowledge-based economy, capital is knowledge, capital is discovery, capital is information, capital is learning, and capital is trial and error. It is not just bricks and mortar at all. In fact, today the really important capital investments are not in hard assets of the kind accountants recognize. We need to shift from a medieval definition of capital as the castle on the hill to the recognition that capital also includes investments in everything and anything that makes a company better and more capable of earning profits. And for that, EVA uses full-cost accounting. All investments, successful or not, are considered to be capital. And let me reiterate before you object to this that capital is not an asset and capital is not value. Capital is simply a raw material ingredient spent with the intention of creating value. Putting more ingredients into the capital accounts only sets up a higher capital charge hurdle for success. A greater profit must be earned to cover the full-cost capital that now appears on the balance sheet.
To convert from the successful efforts method that accountants prefer to the full-cost treatment that makes business sense and economic logic, losses on sales are added back to earnings and also added back to capital. It is double-entry bookkeeping, once again and always. The loss cannot be legitimately added back to pro forma the earnings without also making the corresponding add-back to the capital account. That wouldn’t be cricket, and it would not be correct.
To continue with the Coke numbers, the $50 book loss is added back to NOPAT and also added back to capital. As a result, and as was originally the case, NOPAT is unaffected by the loss. It simply records the recurring profit stream from the business, which is a $10 reduction—the original effect of switching from steel to disposable paper containers. As for capital, the accountants reduced it by the $200 book value, but once the $50 loss is added back, capital decreases by only $150—by the after-tax cash proceeds. What shows through, thankfully, is the $5 increase in the EVA, which stands tall as a reliable measure of the merits of the decision.
EVA = NOPAT − COC × Capital
−$40 = −$60 − 10% × −$200 (Accounting picture)
+$45 = +$50 − 10% × +$50 (EVA adjustments)
+$5 = −$10 − 10% × −$150 (Economic reality)
It sounds complicated when you have to unwind the accounting, but that is because we have to undo the damage the accountants have done in the first place. Blame them, not me, for these complications. But also, to make it easier to understand what’s really going on, think of it this way.
Under EVA, it is as if the only accounting entries were simply to debit the cash account by $150 to record the stainless steel sale proceeds coming in the door, and to credit (reduce) the capital account by $150 (leaving an unrecouped $50 of book value in capital). That’s it. Nothing passes through the profit and loss (P&L) statement, because this is a capital gain or loss from a capital transaction, and capital gains and losses belong in the capital account—get it? Under EVA, the purpose of the balance sheet is not to show the assets; it is to record capital. It is simply to ask how much money has been put into the business with the hope and expectation it will create profit, generate EVA, and add to value, net of (less) any capital that has been retrieved from a sale or liquidation. When you start to think of your balance sheet as a capital account, and managers as stewards of capital, then you are getting closer to the EVA philosophy of management accounting.
Replacing generally accepted accounting principles (GAAP) balance sheets with the EVA accounting treatment for capital is an important way to unlock real value, in my experience. It tells managers to get rid of all assets that are really worth more to others and not to let bookkeeping losses stand in the way of their common sense. Instead, follow this rule: If the proceeds from disposal, reinvested at the cost of capital, produce more profit and a greater discounted EVA value than continuing to hold the asset, then sell it, and don’t let accounting red ink stand in the way. That’s the simple, clear thinking EVA brings to the fore.
I remember that up until we put EVA in place at Centura Bank of Rocky Mount, North Carolina (since acquired by RBC Bank), around 1997, management had been warehousing land in locations where it thought it might want to build branches down the road. Once EVA came in, management discovered that the bricks-and-mortar branches were not as EVA profitable as putting kiosks in Wal-Mart stores and other capital-conserving locations. The edifice complex was gone, just in time to take advantage of the swing to online banking. But rather than sitting on the land to avoid recognizing any loss, as many companies would have done, management stepped in aggressively to sell the properties and take a loss on the tax books that brought in more cash flow and reduced capital even more. It was a great EVA move that cleared a path into a whole new business model that might have been stymied had management let the appearance of an accounting loss stand in the way of realizing a real EVA gain.
Incidentally, gains are treated symmetrically. An unusual one-time gain on sale is removed from NOPAT, reducing it, and it is applied as a reduction of capital. It is an extra recovery of capital that permanently reduces the capital charge and increases EVA, presumably substituting for the earnings power lost by selling a productive asset for a gain, and making it possible to make a rational hold or sell decision.
Either way, with a gain or a loss, the EVA mandate is to dispose of assets where the after-tax sale proceeds, invested at the cost of capital, exceed the NOPAT earnings that are forfeited in the process. That is the correct, incremental, strategic NPV decision. It is easy for line teams to understand, and it motivates them to comb through their balance sheets and find tons of asset redeployment opportunities that might otherwise be off their radar screens.
RESTRUCTURING COSTS ARE INVESTMENTS, TOO
Management teams occasionally fashion an overall program to sell, cut, change, and transform in order to bring about a comprehensive redirection and restructuring of the company. Management will estimate the overall cost of the program, immediately charge it to earnings, and set up a restructuring reserve on its balance sheet to absorb the write-downs and cash costs as they occur.
The accounting for this kind of bold move is downright misleading and can even be a deterrent to restructuring a business line. Who wants to fess up to a large loss and pour red ink on the bottom line? Usually, no one other than a new CEO or division head who can blame the mess on his or her predecessor. But shareholders and directors don’t want to wait for management changes in order to do the smart thing. And they don’t have to when EVA is accounting for the consequences.
In the EVA world, the accounting for restructuring charges is much the same as for impairments or disposal losses The charges are added back to the earnings to reveal the underlying, ongoing earnings power of the business, and in exchange, the restructuring charges are folded into the same balance sheet capital account as is used for accumulating losses on sales. Think of it as a kind of goodwill account. It is abstract organizational capital, but it is capital nonetheless; it is money put into the business for an intended benefit, and it is subject to the cost-of-capital charge as a matter of maintaining accurate debit and credit bookkeeping.
Assuming that managers are judged—and rewarded—according to EVA measured this way, what are their incentives? Fail fast, and fail well. Step in and restructure and redeploy assets as soon as it is sensible to do so. Don’t hesitate over fear of a mere bookkeeping charge. But, fail well. Just because accountants lump all the restructuring costs into a great one-time charge to earnings doesn’t mean that managers have a license to spend wantonly.
I recall a recent conversation with the CFO of a major packaged goods company that was in the midst of planning the details of a comprehensive restructuring to consolidate product lines and streamline processes. He said, “Bennett, ever since I got board agreement for the restructuring program, my line guys have been looking for ways to take advantage of it. They are proposing to spend a lot more money on revising our processes and restructuring our businesses and paying out generous severance than they really should, just because they know it’s all going to get lumped into a one-time charge to our earnings. They think it almost doesn’t matter what we spend, that the market will digest it and move on. That cannot be true. Cash is cash. We’ve got to earn a return on it no matter how the accountants treat it. But the accounting is not helping me to get that message out.”
He’s right. Any cash outlay that does not directly or indirectly support current operations and that is spent with the intention that it will have a payoff stretching into future periods should be capitalized and written off over time, with interest. We can’t do that comprehensively, of course. We’d suffocate under the details. But it certainly applies to one-time restructuring costs. You invest in a restructuring to streamline costs and increase profit performance. You have to earn a return on the capital invested in the restructuring and cover the cost of that capital the same as any other investment. If not, why are you doing it? If you cannot cover the cost of the capital invested in the transition, you might as well stick with the old ways, even if they are not as profitable as the new ones.
That is why under EVA we add restructuring costs to the balance sheet as an investment, subject to the capital charge, so that managers are pressured and obligated to earn a return on them. The EVA treatment removes the fear of failure, but it also sets a performance standard. The incentive is to spend only the restructuring dollars that will truly add an incremental return over the cost of capital. This is a sure cure for the “everything but the kitchen sink” syndrome.
Along these lines, I vividly recall a meeting with Victor Rice, at the time the chairman and CEO of Varity Corporation, the successor to Massey Ferguson, a Canadian farm implement manufacturer that had relocated to Buffalo, New York. I said, “Victor, I have bad news. According to my calculations, Varity’s EVA is currently running at a loss of $150 million a year.” He replied, “I am not surprised. This is a tough business. Farms are consolidating and the equipment is lasting longer. We’ve been in a consolidation phase so long that we kid ourselves by saying that a typical year in our business is worse than the year before but not as bad as year to come. Even so, we’ve continued to hope for the best,” he said, “and we’ve put off plant consolidation and process rationalization for way too long. We desperately need a major revamping and restructuring, but we know that will lead to a lot of bookkeeping bloodletting, with major charges to our earnings. How can we demonstrate that we are winning when the accounting will say we are losing?”
I told Victor about using EVA and shielding the earnings from the restructuring charges and treating them as investments. He loved it. And his team did it. And over the next two years, Varity’s EVA improved dramatically, from −$150 million to −$30 million, amid a sea of red accounting ink. Bonuses, based on the change in EVA, were very rich, and the managers were ecstatic, as I recall, but the shareholders were downright delirious because the stock increased 250 percent in value. True, EVA was still negative, but it had gotten a lot less negative a lot faster than investors had imagined it could, and the special EVA accounting for the restructuring was a real enabler for that to happen.
R&D AND BRAND SPEND ARE INVESTMENTS
What are the most important capital outlays at companies like Intel, Genentech, IBM, Coca-Cola, Nike, and Coach? Spending on research and innovation, on developing and launching products, and on building brands, of course. It’s what differentiates the companies and enables them to charge premium prices and generate outstanding returns.
And yet, despite the obvious and even quantifiable value of the brands and technology, accountants immediately write off the money spent on developing them as a charge to earnings. They deduct the spending as if it has no enduring value and is just a period expense in support of current sales, which is patently false. We’ve already discussed successful efforts accounting, which is where accountants only allow oil and gas companies to record the money spent finding productive wells as assets and force them to expense the dry holes. The accountants are not even that generous with research and development (R&D) or brand building outlays. It is all expensed regardless of success. They assume failure is the norm. I call it “unsuccessful efforts accounting.” Their justification, again, is that intangibles cannot be relied on to have a value in liquidation. That is growing increasingly untrue—witness all the talk about the value of the Twinkies brand when Hostess entered liquidation or Kodak’s ability to auction off its brands and technology in bankruptcy—but accounting is a profession still stuck in the dark ages.
What is a better and more realistic answer? Under EVA, spending on R&D and brand building, on designing and launching new products, even on training programs, and, in some cases, on maintenance outlays that are deemed critical are added to balance sheet capital and are written off as a charge to earnings over time, subject to a capital charge on the unamortized balance. We generally write off R&D over five years and advertising and promotion spending over three years, but that varies for individual companies. In a typical example, if R&D spending increased $100 in a period, then it would turn into a $20 amortization charge per year over a five-year period, plus interest at the cost of capital charged on the unamortized balance. Spending on intangibles, in other words, is treated just like capital expenditure spending for plant and equipment, except that it is added to a special balance sheet account for intangible capital (which I discuss in more detail later on).
This follows an economist’s view of the world, in which capital is defined as any cash outlay that is expected to generate benefits that extend over future periods. In principle, all spending that qualifies should be added to balance sheet capital and amortized against earnings over the expected payoff horizon. Those expectations may not be realized, but that is what EVA will tell us, not the balance sheet. I am not staking my claim to this EVA accounting treatment on theoretical grounds and by an emotional appeal to a higher economic calling. I want to be ruthlessly practical. I am advocating that you use the EVA accounting for intangibles because it will help your team to make better, and better informed, decisions with more accountability, clarity, and insight.
For instance, by spreading the cost over time, EVA discourages managers from opportunistically cutting the spending just to make a short-term earnings goal. Why cut $100 from R&D this year if it saves only $20 (plus interest) this year? That’s just not an appealing or intelligent way to make budget, assuming that the R&D spending is worthwhile.
On the contrary, the EVA accounting treatment motivates managers to step up the spending if they think it will yield a high return on investment. Increase R&D by $100 this year, and the charge to EVA increases by only $20 in the current period, plus interest. The revised accounting treatment gives managers the time needed to make their proposed investments pay off rather than hitting them with the full expense right up front. It better matches cost and benefit.
In exchange for providing more freedom to invest in brands, people, processes, and technology, the EVA accounting also imposes more accountability for actually generating results. As President Reagan once put it in discussing nuclear disarmament, “Trust, but verify.” With the EVA accounting, managers know that if they successfully lobby for the funding they will be obligated to cover the full cost, including interest, over time, and they know their success or failure will be transparently posted on the EVA scoreboard for all to see, and ideally, in the bonus awards they earn or fail to earn.
Managers in most companies define success as getting their proposed R&D, advertising, product launch, or training budgets approved. In the EVA company, success is defined as delivering value—actually getting a return on the investments and driving growth in EVA. Managers in most companies are loath to cut any spending for fear they could never get it back in their budgets. In the EVA-focused firm, managers are more likely to cut the spending that should be cut, knowing that they have the credibility to get it back should an appealing opportunity materialize down the road. Budgets are both more fixed and more flexible under EVA. There is a greater incentive to keep investing through thick and thin as long as the return is perceived to be there, and there is also more incentive and more credibility to alter the budget—up or down—as an honest reappraisal of the payoff dictates.
I will give you three examples of how the EVA accounting technique changed strategies for the better. Shortly after adopting EVA, Monsanto announced its intention to step up R&D spending by 40 percent at its G.D. Searle pharmaceutical unit. The unit had five drugs in stage-three clinical trials, and by stepping on the accelerator, Searle could prove the products faster and bring them to market sooner. The payoff could be big. Not only would the revenues and profits begin to accrue earlier, which counts as more discounted value, but they would likely last longer. The patent protection clock starts ticking from when the patent is first filed, so the sooner to market, the longer the effective patent life would be. In addition, doctors grow accustomed to prescribing the first therapy to market, which also sets up a barrier to deter new entrants or make it harder for them to gain share. In short, there are very good reasons to think that stepped-up R&D spending at that stage could drive significant EVA gains. But that rarely happens in practice because most pharmaceutical companies are afraid of the near-term negative impact on reported earnings per share. They let the accounting tail wag their business dog, as my former partner, Joel Stern, memorably put it.
Monsanto was well aware of the EPS impact, but did it anyway. CEO Robert Shapiro admitted in the press release that the increased R&D spending would significantly dilute the firm’s reported earnings. Mark Wiltamuth, at the time a highly respected securities analyst at Natwest (now with Morgan Stanley), estimated that Monsanto’s per-share earnings would drop from his prior estimate of $1.60 to $1.40 the next year, or by 12.5 percent. Yet Monsanto’s stock price increased from about $38 to $40 a share that day, or about 2.5 percent. Put another way, Monsanto ended up trading for a 15 percent higher price-to-earnings (P/E) multiple, which more than countered the 12.5 percent EPS dilution. The market apparently responded favorably to the prospect of an increase in the present value of EVA rather than to the misleading near-term accounting appearance. And this is not an isolated example. Numerous empirical studies have shown that when accounting and economics diverge, the market responds to the expected long-run economic value in the short term—right away. The P/E gives way to the EVA.
The contrary view is what I call the accounting model of value, which I covered informally before. To be more precise, it says that a firm’s share price, or P, equals its earnings per share (EPS) times its price-to-earnings (P/E) multiple, to wit, P = EPS × P/E. This is of course always true because the P/E multiple is solved for as a plug figure. A stock that trades for $10 a share, with $1 in per share earnings, trades for a P/E of 10. In fact, it is a tautology, not a valuation model. But some can’t resist thinking it is a valuation model. Having written the formula down, it is tempting to conclude that an increase in EPS must translate into an increase in share price, and vice versa, because the P/E multiple is a given. Take EPS up to $1.10 a share, and the stock price rises to $11 a share, says the model. And don’t dilute EPS to $0.90, because the stock price will nose-dive to $9. This screams at Monsanto to not step up the R&D and crush earnings. Of course, the EPS model was not right for Monsanto, and is not right in any case. But why is it wrong?
The accounting model makes a big assumption. It assumes that, regardless of what is driving the EPS up or down, the market is so simplistic and myopic and really so stupid that it just mechanically assigns the same P/E multiple no matter what. That is a highly theoretical proposition that turns out to be dead wrong in practice. P/E multiples change all the time to reflect a change in the quality of the earnings.
I have already discussed how an increase in a firm’s leverage ratio, such as to borrow and buy back stock, reduces the multiple. It increases the volatility and decreases the quality of the bottom-line shareholder earnings, which renders EPS a poor guide to the stock price. An increase in spending on intangible assets has the opposite effect. A spending hike decreases EPS in the short term, but if an honest appraisal of the strategy shows that it is likely to increase EVA, then the company’s share price will respond favorably, and right away, as it did with Monsanto, and the P/E multiple will more than take up the slack. In this case, there is an increase in the quality of reported earnings, because the current earnings are pregnant with the potential payoff from the current R&D spending. Once again, given this, a CFO or board member cannot really judge the value of a decision or how the market will respond by looking at near-term EPS. One must also ask what will happen to the P/E ratio. But how can one determine that?
Quite simply, abandon the idea that stock prices are set by putting a P/E multiple on EPS. Instead, forecast what will happen to EVA and discount that to determine the stock price, and then just derive the P/E ratio from that. If EVA shows a win, and the accountants inform us that EPS will be diluted for whatever reason, then you can safely conclude that the company will trade for a higher price-to-earnings multiple, that is all. You solve for it. You may not always be right, of course, but there is no question that you will more likely reach the right decision if you put it in terms of its impact on EVA than in terms of EPS.
To reiterate, the accounting model of valuation assumes that the P/E multiple is fixed, so EPS is all, while the EVA model assumes the present value of EVA is all, and the P/E multiple is just a plug. The evidence backs common sense. P/E ratios are plugs. EVA wins; EPS loses.
The second example I want to share comes from Kao USA, at the time known as Jergens Inc., the hand lotion company that had been acquired by the leading Japanese consumer products company, Kao Corporation, often referred to as the Procter & Gamble of Japan. I was invited in by the CFO to present EVA to the Japanese board that oversaw Jergens to help resolve a culture conflict.
The Japanese were uncomfortable with confrontation and did not like having to negotiate budget goals that became the basis for determining annual bonuses for the American management team. They felt, as I do, that that process is often highly counterproductive, that it tends to corrupt planning and make senior managers and subordinates into adversaries instead of partners. George Sperzel, the CFO at the time, saw EVA and the EVA bonus plan as the perfect way to reconcile the occidental demand for cash bonuses and the oriental aversion to confrontation and negotiation. I must have been good that day, because I was able to convince the board to commission the adoption of EVA and the bonus plan with automatic target resets. And it worked so well that a few years later, Kao became the first Japanese company to fully adopt EVA, but that is another story.
Shortly after adopting EVA, Jergens was launching a new skin cleansing patch developed in Japan named Biore. The marketing department followed standard procedure and prepared a typically aggressive plan to advertise and promote the product, which inevitably would lead to invitations to lavish dinners hosted by sundry fashion magazines and other media to pitch their advertising outlets. Sperzel stepped in and reminded the marketers that, under EVA, all the money they spent launching the new brand would be captured, capitalized, and written off over time, subject to cost of capital on the balance, so that if they overspent and did not deliver value, EVA would suffer and their bonuses would, too.
The gentle reminder led to a wholesale change in strategy, in effect from push to pull. In an about-face, the Jergens marketing team paid to entertain the magazine editors to sell them on the merits of articles describing the benefits of cleaning skin with an absorbent patch. Jergens stepped up trade show promotions and in-store displays and demonstrations. In short, Jergens looked for ways to make the product go viral before that was even a phrase. The result: Biore was EVA positive the third month from launch, which had never before happened in the company’s marketing experience and was a key factor in the parent company’s decision to adopt EVA in Japan.
A third way the EVA accounting produces better decisions is in neutralizing build versus buy choices. I recall going over the EVA treatment for capitalizing R&D spending with the vice-chair of a major tech company not long ago. After hearing me out, he confessed he wished we had spoken four years earlier. The company at that time had reached a critical juncture where it could either step up its tech spending to keep pace or punt. Management punted out of concern that a sharp increase in spending would be a drag on the firm’s EPS record. The vice-chair said, “Bennett, now we have to go out and pay premium prices to buy the technology we could and should have developed on our own. The irony is that accounting says tech is an asset if you buy it but not if you develop it, but in the real world it is almost always the opposite. I really like your EVA approach. It puts buying and internal development on the same footing, so as a management team you are more inclined to make the right decision based on its economic value rather than its accounting appearance.”
CFOs sometimes ask me to predict whether their company will spend more or less on intangibles with the EVA accounting treatment. As the examples show, it depends. Monsanto spent more, Jergens less. The answer is the company will spend differently and better.
A last point is that for any one company, the decision to capitalize and amortize the intangible investments depends on the facts and circumstances. For each type of intangible, ask: Is it material? Can we track it? Is it a variable that our managers can actually manage, and will they understand and respond to it? If not, keep it simple and just expense the outlay in accord with conventional accounting. But where the behavioral and managerial and analytical benefit is worth the extra tracking cost, then do it. At EVA Dimensions we’ve developed a set of software tools that automate the computations and correctly integrate them into the EVA metric set, which has reduced the cost of tracking the adjustments. For public companies, the software is coded to automatically amortize its reported R&D over five years (10 years for pharmaceutical and biotechnology companies) and advertising and promotion over three years (five years for pharma and biotech). That’s the starting point, and it serves as a useful reference that any one company can alter and customize for internal use.
BAD DEBT RESERVES
Bankers have a curious practice. When they make a loan, they immediately write off one or two or three cents on the dollar as a loss. Why? Because they know loans are risky and some, inevitably, will not be repaid in full. But the banks don’t just absorb the losses. They expect to offset the losses, plus cover their operating costs and interest expenses—heck, even to earn a decent return on capital—by jacking up the rates charged to all borrowers. Which raises the question: If the bankers prebook the losses they foresee on deadbeat loans, why aren’t they prebooking the profits they expect to make off the loans that will be repaid? Because the accountant’s motto is: when in doubt, debit. When in doubt, take a charge to earnings, set up a reserve, and be conservative.
But in running a business and in judging the shareholder value of a going concern, the better rule is not conservatism but realism. And in this case, the reality is that when times are good and profits are lush, managers inflate the provision for bad debts and squirrel away earnings in the reserve. Then when tough times hit, they underprovide for the actual losses they experience and draw down on the reserve, and that helps them smooth reported earnings. It is a classic example of the “cookie jar” reserve. While it may be a common practice, it is not a good idea at all. The practices don’t just divorce reported profits from what is really happening at any given time. The manipulation is a transparent and fundamentally unethical attempt to paper over problems and fool the market, and to smooth bonuses. That is the slippery slope to the Enron zone.
EVA says, “Let there be light.” The loan loss reserve is added back to the loans, so loans appear in the EVA capital base at the face value of what is owed. And instead of running the accounting estimate of losses—the so-called loan loss provision—through earnings, it is ignored and in its place the loans that actually go bad in a period are charged off against the EVA earnings. That way, if a loan is delinquent, the operating team is galvanized to collect it, because if they don’t, it becomes a charge to that period’s EVA earnings. And the next time they extend credit, they are motivated to think twice. In other words, this shifts attention from what the accountants can manage—the book provision—to what line managers manage—credit decisions and the ensuing actual losses and recovery efforts. The same applies in an operating company on its receivables and bad debt provision. It is the same EVA accounting, with the same beneficial consequences.
DEFERRING TAXES ADDS VALUE
There’s nothing certain but death and taxes, so, given an alternative, let’s talk tax. A problem is that companies never pay the tax that their accountants say they pay. Accountants compute tax as if it was due on the book income they measure, while companies actually pay tax on their taxable income, which is figured with a different set of rules using a different set of books. One example is that companies are able to write off their plant and equipment faster on their tax books, which postpones taxes compared to the reported tax. Other rules lead to tax prepayments. For example, accountants deduct an estimate for warranty costs when a sale is made and accrue employee compensation costs, but tax rules allow deductions to lower taxable income only when the costs are actually paid, which occurs at a later date.
Accountants true up the difference between book taxes and cash taxes on the balance sheet. When tax payments are delayed, a so-called deferred tax liability account builds up on the financing side of the balance sheet ledger. That represents a claim on future cash flow. It says that down the pike the company will have to pay more tax than its accountants compute in order to make up for paying less tax in the past. On the other side, when a company prepays tax, a so-called deferred tax asset accumulates on the balance sheet. It is an asset because the company will eventually obtain a refund of the prepaid tax. Either way, the book tax number is just a fiction, and changes in the deferred balance sheet accounts reconcile the accounting earnings fiction to the economic reality of when taxes are actually being paid.
Here’s the rub. There is a real value to paying taxes later rather than sooner (i.e., for building up a deferred tax liability), because no interest is charged on the deferred tax liability. It is effectively interest-free capital. It reduces the amount of debt and equity capital the company would need to finance its net business assets and that would otherwise burden EVA with a capital charge.
The opposite applies for a deferred tax asset. There is a real added cost to finance the tax prepayment with capital. And yet, again, sadly, accounting books just completely ignore the timing value of when taxes are actually paid. This is a gross error, because industrial companies materially benefit from deferring lots of taxes, while others, like retailers, don’t have nearly as many tax advantages. Systematic errors in judging performance are introduced if deferred taxes are buried on the balance sheet and essentially ignored, as most performance measures do. EVA gets it right.
There are three ways to recognize the timing value in EVA. The first approach, which I do not recommend, is to convert the book tax provision to cash taxes. For instance, if a company started with a net deferred tax liability balance of $70 and ended the year at $100, the $30 buildup would be added to NOPAT, and the $100 deferred tax liability balance-sheet account would be moved into equity capital, just as if the accounting provision for tax had been equal to the cash tax payments all along.
That is correct as far as it goes, but it introduces a lot of unwanted volatility into the EVA earnings because cash taxes fluctuate, sometimes by a lot. There are many reasons why that happens. Companies occasionally negotiate tax settlements that trigger a one-time tax payment or credit. Another is that U.S. tax rules have recently offered a temporary incentive to acquire equipment, called bonus depreciation. Another technical problem is that deferred tax accounts change when assets are acquired or sold to reconcile differences in the book tax carrying values. Whatever the reason, measuring EVA with cash taxes misrepresents sustainable profitability and distorts performance comparisons.
The second approach avoids that problem. The procedure is to include the deferred tax asset accounts in capital, subject to the capital charge, and to deduct deferred tax liability accounts from capital to offset the capital charge. The more money a firm has tied up in prepaid taxes (i.e., in a deferred tax asset account), the lower its EVA is, while the more it has built up a deferred tax liability account to fund its business and reduce the need for capital, the bigger its EVA is. As with the cash tax procedure, this one provides the right incentive—find legitimate ways to pay taxes later rather than sooner—while avoiding its deficiencies. One-time or temporary blips in cash taxes are absorbed into the deferred tax accounts and converted into an annual earnings equivalent.
Although that is a perfectly legitimate way to handle deferred taxes, a disadvantage is that it complicates capital. Deferred tax asset accounts are mixed in with the operational assets that line teams manage, and deferred tax liabilities confoundingly offset capital. That adds a layer of complexity in explaining what goes into capital, which is already a bit of a struggle for operating people. Why compound that?
This leads to the approach EVA Dimensions recommends. It is to recognize the value of deferring taxes via a direct adjustment to the tax deducted from EVA. To do this, deferred tax assets are not included in capital, and deferred tax liabilities are not deducted from capital—capital remains operationally focused. Instead, the tax on NOPAT—and thus on EVA—is reduced by the cost of capital saved from the net balance sheet deferral of taxes.
For example, suppose a company carries a deferred tax liability on its balance sheet of $160 and recognizes a deferred tax asset of $40, for a net deferred tax liability of $120, and its cost of capital is 10 percent. Then $12—the cost of capital saved—is deducted from the NOPAT tax. This produces the same EVA as the prior method but without the capital complications. It just takes the cost of capital effect and dumps it right into the tax account.
Besides keeping taxes out of the capital accounts, all tax items are consolidated into one effective tax and tax rate rather than being spread over the income statement and throughout the balance sheet. As important, it preserves the correct incentives. Business managers are motivated to collaborate with the company’s tax department to implement strategies that will legitimately postpone tax payments and reduce the tax on EVA. As one of my clients put it, “Now that we are measuring EVA posttax with this system, the tax department has become an EVA profit center for us. We’ve come to realize that a dollar of tax saved is just as valuable as a dollar of profit earned.” Then he corrected himself. “That is not quite right. The dollar of tax saved is better than the dollar of profit earned, because profit is taxed.”
SMOOTH TAXES
In any one year and for many reasons, companies may report taxes that are dramatically more or less than a normal amount. Here is one example taken from PepsiCo’s 2008 Annual Report:
In 2007, we recognized $129 million ($0.08 per share) of noncash tax benefits related to the favorable resolution of certain foreign tax matters.
In 2006, we recognized noncash tax benefits of $602 million ($0.36 per share), substantially all of which related to the Internal Revenue Service’s (IRS) examination of our consolidated tax returns for the years 1998 through 2002.
There is nothing at all wrong with what Pepsi reported. Management was just following the rules and living with the natural give-and-take of negotiations with tax authorities. But that is the point. Unusual and nonrecurring items flow through computed tax provisions and into book profits all the time, which introduces an unwanted source of noise into corporate profit measurement. EVA quiets the noise by establishing a normal or standard corporate income tax rate and then applying that rate each year to the firm’s pretax operating income to estimate the tax that is deducted from NOPAT. Mind, we do not want to ignore one-time tax events, but we do want to smooth them out and convert them to the equivalent of an annual earnings impact.
How? By deferring them, and crediting them with the cost of capital. To be specific, EVA creates a separate deferred tax account (I call it the created deferred tax account) to hold the accumulated difference between the assumed smoothed tax and the accountant’s tax provision on operating profit. If the smoothed tax computed at the standard rate is more than the provision, then a deferred tax liability is created, because the company’s provision was for some reason less than the normal rate that year, and vice versa. The created deferred tax account is then treated the same as the ordinary balance-sheet deferred tax accounts. The cost of capital saved on a net created deferred tax liability is applied as a reduction in the tax on NOPAT (and EVA), and vice versa.
An example will make it easy. Suppose we’ve established that a firm’s normal, ongoing, effective tax rate on its operating profit runs at 33 percent. If it records $100 in operating profit, then $33 is deducted from its NOPAT and, by extension, from its EVA, as the normal or standard tax provision. Suppose, though, that the company’s book tax provision on operating profit that year was only $25—perhaps due to a shift to foreign source income taxed at a lower rate, an unusually large R&D credit, or a one-time tax settlement like at Pepsi. Then the $33 tax charged to EVA overstates the actual tax provision by $8, and that is added to the created deferred tax liability account and is carried forward forever. The opposite applies if the actual tax provision on operating profit was greater than the EVA standard tax.
Over time, if the standard tax rate accurately reflects the company’s typical tax rate, the plus and minus adjustments should offset, and the created account should approximate zero in the long run. But over the short term, there will be deviations—that is the whole point, to smooth the fluctuations—and a net created deferred tax liability (or asset) account will accumulate. It is treated the same way as the company’s actual deferred tax accounts. Interest at the cost of capital rate on the net created deferred tax liability is applied as a separate reduction in the tax on NOPAT (and thus on EVA).
When the dust settles, the tax deducted from EVA is a smoothed tax (at the assumed standard rate) less a cost of capital credit for the overall net deferral of taxes relative to the assumed smoothed tax. We get there in three steps, but that is the net effect of what happens. This treatment provides for a consistent and comparable assessment of after-tax performance while providing line teams with all the desirable incentives to factor taxes into their decisions and to legitimately defer or permanently reduce taxes. And it does not make the mistake of mixing tax items that happen once in a while with items that happen all the time. A transitory reduction in tax is converted to ongoing earnings equivalent by multiplying it times the cost of capital.
FIX RETIREMENT COST DISTORTIONS
Perhaps nowhere is accounting more befuddled than in defined-benefit retirement plans. To clear this up takes a bit of huffing and puffing, I am afraid, but it also brings together many of the issues we’ve discussed. This is your final exam on correctly accounting for value. Feel free to skip ahead if this is not your cup of tea or if it is not applicable to your company.
What is the real operating expense a company incurs in a period from its defined-benefit retirement plans? It is the increase in the present value of the liability for future benefit payments that arises from employee services in the period. Fortunately, there is a name for that. It is called the service cost. It represents the amount of money that a company would have to set aside and invest in safe bonds to meet the estimated future obligations incurred during the year. And if a company actually did set aside that money and did invest it in low-risk government bonds that were maturity-matched to the obligations, its accounting cost would equal the service cost in every period.
When we measure EVA, we assume a company did that, regardless of whether it actually did. We pretend the plan sponsor did fund its service cost each year with safe bonds, and we recognize the service cost as the charge to EVA. We consider that to be the best measure of the expected cost of the service in that period. It also appealingly separates the operating cost from assumptions about how the cost is financed. It does not mix legacy issues and pension funding strategies into the measurement of operating profit performance.
Here’s the rub. Most companies do not do that. They do not fully fund their plans each year with bonds. They speculate. They mismatch contributions to the retirement fund compared to the service cost, which means they are effectively either borrowing money from or lending money to the retirement plan, and, worse, they don’t invest the retirement assets in safe bonds with maturities matched to the retirement liabilities. They typically go for a mix of bonds and stocks and alternative investments. And they do that for two reasons.
The first is that CFOs are convinced that they can earn a higher return by investing retirement assets in a diversified market portfolio than by investing in safe bonds. Why not earn a higher return to reduce the cost of funding the pension promises, if that is possible? Answer: because a higher return is available only from, and in compensation for, taking more risk, so that after considering the added risk, there is no benefit at all to earning the higher return. A company’s shareholders would be as well off if the pension plan were invested in bonds as in stocks (in fact, there are good arguments that they would be better off, but that is a topic for another book).
The argument for investing retirement assets in a risky portfolio is seductive. It is like saying that if you have $1,000 to invest, never invest it in safe government bonds. At least invest your money in a portfolio of BBB-rated corporate bonds and snatch the higher return. Why invest $1,000 and earn just 2 percent on government paper these days when the available yield on a triple-B bond portfolio is 4 percent, let’s say? Why would you ever settle for $20 in interest income when you could earn $40? Why not earn more?
The answer, obviously, is that triple-B bonds are riskier, and the market has set the price—available to anyone—to compensate for that risk. They are not as safe or liquid or stable as government bonds, and the transaction costs in and out are generally higher. Lower-rated bonds are more volatile—their value tends to rise and fall with the market and the economic cycle. They have nondiversifiable beta risk. And, worst of all, lower-rated bonds can go AWOL just when you need their assistance the most. Their yields may shoot up and their prices may fall much more precipitously when there is a flight to quality and liquidity. As a result, investors understandably expect and demand to earn a higher return for bearing the higher risk and illiquidity of the lower-rated bonds. But note that the higher return does not make the lower-rated bonds more valuable. The higher return is what is required to make them worth just the same. An investor pays the same $1,000 today for a corporate bond portfolio that promises to pay $40 in interest a year as for a low-risk government bond portfolio that promises to pay only $20. The value is the same because the 4 percent corporate bonds are discounted at a 4 percent cost of capital rate, and the 2 percent government bonds are discounted at 2 percent, as is appropriate for the risk. And this is precisely why there is no benefit to investing retirement assets in a risky stock market portfolio instead of safe bonds. In both cases you start off using the same amount of money to buy marketable securities at market prices and earn a market return that is commensurate with the risk. But many CFOs forget this fundamental truth and are seduced by the superficial prospect of earning a higher return.
The second reason CFOs speculate in pension plans is that the accountants have rigged the bookkeeping rules in favor of taking pension risk in two ways. First, accountants allow companies to offset the service cost and the accrual of interest on the accumulated service cost with an assumed rate of return on the retirement assets. As I have argued, the risk-adjusted rate of return should be the same regardless of the retirement portfolio, and should be the same as the rate used to discount the service cost liability, but accountants do not do that. They take the world at face value, and they allow companies to use a higher assumed rate of return if they invest the retirement assets in a risky market portfolio than in a bond portfolio. This accounting convention enables companies that invest in a market portfolio to reduce their reported retirement costs and report them as lower than what they really are, considering the risk.
It gets worse. The difference between the present value of the projected retirement benefits and the current market value of the retirement assets is a plan’s so-called funded status. Funded status can swiftly turn negative if the stock market takes a swoon. Under current accounting rules, a funding deficit is recognized on the accounting books as a minimum liability and a corresponding reduction in book equity, but the charge to recognize the funding deficit does not pass through ordinary profit channels. It is recognized through a back-channel, rear-door profit measure called other comprehensive income (OCI). Out of sight is out of mind. CFOs basically ignore it because it does not affect reported earnings or earnings per share (EPS). The added risk of investing in a market portfolio compared to investing in safe bonds is swept right under the carpet and ignored. Okay, if the funding deficit gets really large, then the accountants are stirred to run a charge through conventional profit channels. But guess what? They amortize the deficit charge over very long time frames of up to 20 years. In other words, the accountants take the investment risk, which is always a short-term fluctuation, and morph it into an innocuous long-term nonevent. This is simply unforgivable nonsense.
Nevertheless, the accounting rules are the rules, and the rules have misled most companies into speculation that really has no economic substance or added market value. Funding a fixed obligation with an uncertain market return can generate excess returns only at excess risk. It doesn’t pay. We’ve seen this movie before. This is another prime example of how a CFO can goose up reported earnings and earnings per share, yet gain no traction in the stock market, because the market will penalize the stock with a lower price-to-earnings (P/E) multiple. As with borrowing to buy back stock, the EPS gain from following a risky pension investment strategy is countered by a loss in P/E multiple. Here too, the market sees through the accounting appearance. How? With EVA, of course. EVA lifts the veil and shows the warts and all. We’ll need three steps to do it.
First, as mentioned, the true retirement cost in a period is the service cost and not the retirement expense that accountants report. The reported cost is added back to the earnings to get rid of it, and the service cost is deducted instead. With that, the incentive to invest in a risky market portfolio is eliminated, and the true expected ongoing cost is used in its place. That is the appropriate charge to use when judging operations managers and when making forward-looking business decisions. Irrelevant prior funding gains or losses or funding decisions should not be intermingled with future incremental business decisions.
Second, all the retirement accounts that the accountants have unhelpfully spread all over the balance sheet are consolidated into one net liability account. All retirement assets are brought over as an offset to the retirement liability. The minimum liability charges buried in the OCI retained earnings account are removed from equity and deducted from the retirement liability (which was increased to recognize the minimum liability in the first place, and now is back to where it was before recognition of the minimum liability). The cumulative service cost is added to the net retirement liability account, and the cumulative reported retirement costs are deducted from it. In other words, the retirement liability (and common equity) is adjusted to what it would be if the service cost was the reported cost all along and as if no minimum liability had ever been recognized.
When the dust settles, the retirement liability account is the cumulative difference between the service cost that increases the liability and the cash contributions to the retirement plan that reduce it. It is the net borrowing from or lending to the retirement plan. If a company always fully funded its service cost and invested in safe, matched-maturity bonds, then the net retirement liability computed per the previous formula would be zero. If there is a net retirement liability, then the company has not fully funded its service cost, and is effectively borrowing from the retirement plan. And if it is negative, then the company has put more funding into its retirement plans than its service cost, which is generally not a good sign. It could be prefunding the plans, but more likely that means the returns on its retirement assets have been so low that the company has had to ante up a surplus just to stay in the game.
One more step to go. The third adjustment is to recognize the cost of closing a funding gap—or the earnings equivalent of a funding gain, if the company should be so lucky. This begins by measuring the difference between the off-balance-sheet funded status of the plan and the on-balance-sheet net liability computed earlier. If the off-balance-sheet liability is greater, then the company will eventually need to pony up the difference to make the plan whole. The company would have to raise capital to do that. So, the last step is to deduct from EVA the cost of capital charge for the capital needed to close the funding gap, and vice versa for a gain.
For instance, suppose the net funding gap between a company’s off- and on-balance-sheet liabilities is $100, and the cost of capital is 10 percent. Then a $10 after-tax charge is directly deducted from its EVA. The charge appears in our reports under the caption “capital charge on post-employment-benefit (PRB) funding loss (gain).” And in a forecast valuation of the company, the present value of the charge discounted at the cost of capital—which would come to $100 in this case, which is the net unrecognized funding liability—would be deducted from the firm’s NPV and MVA. With this procedure, a funding liability reduces the company’s value directly and visibly, through the present value of the line-item hit to EVA, rather than being sidetracked into the virtually invisible OCI account where accountants stuff it.
It’s a lot to grasp, so let’s step back and run an overall example, building up from a simple situation and layering in more nuance. Let’s start with a firm that has an annual service cost of $100, and assume that management does not fund any of it (ERISA rules require it to, but this is an example). Suppose the safe bond discount rate is 2 percent. Then after two years the liability on the books has grown to $202. It is $100 from the first-year service cost, plus $100 for the second year, plus $2 in accrued interest (it would also be reduced for any benefits paid, but let’s keep it simple).
The plan’s funded status off the books matches the liability that shows up on the books. Here’s how. The plan’s projected benefit obligation recorded in the company’s financial footnotes is $202 (it is the same as the accumulated service cost liability), and with no assets in the plan, that is also the plan’s funded status. As a result, there is no actuarial funding gap as we compute it, because the $202 on-balance-sheet liability matches the $202 off-balance-sheet liability. No adjustment to EVA is made. All that is happening is the company is borrowing from its employees. It is paying them in promises, in effect issuing bonds to them that come due postretirement. There is no cash outlay, but there is a liability recorded that reduces the firm’s common equity book value as the service charge passes through EVA and out of retained earnings, so nothing is missing.
Now suppose the company borrows $202 to contribute to the retirement plan. The entry is to credit the borrowing and debit the retirement liability, which makes the balance-sheet retirement liability zero. Off the books, the retirement plan funded status is now zero, too. The projected obligation is fully funded by the $202 that is now available to invest in a matched-maturity safe bond fund. Forevermore, following the same policies, the company will show a retirement cost that is equal to its service cost. The interest that accrues on the retirement liability plus changes in the value of the retirement liability are always perfectly offset by the total return on the matched bond fund from interest income and from the change in its market value. Life would be simple and sensible if this were the case, and the accounting would accurately and coincidentally mirror economic reality.
But what if, instead, the retirement plan is invested in a common stock/corporate bond/alternate asset mix, as is typical, and as a result, the assumed return on the pension fund is jacked up to 7 percent? The reported retirement cost is now magically less than the service cost. The retirement liability accrues interest at the 2 percent safe bond rate, but that is way more than offset by an assumed 7 percent return from the pension fund. On net, the reported retirement cost understates the true service cost in an amount of 5 percent of the retirement fund assets each year. Book profit, EPS, EBITDA, and ROE all get a nice but quite meaningless free ride. There’s the allure to play the game. Of course, the EVA accounting says nothing of the sort. The cost is still the service cost. Operating decisions and financing decisions are kept separate, once again, as they ought to be.
Suppose, contrary to the assumed 7 percent return, the pension fund falls 10 percent in value. Ouch. Now there is a sizable funded status gap—but in this case to keep it simple we assume it is not so sizable that it triggers additional cost recognition. It will trigger balance sheet recognition, though. The reported retirement liability will be increased and the book equity decreased to recognize the funded status liability. Ironically, the company’s return on equity is inflated even more because the reported book equity is reduced. Oh boy. Bottom line: it was a terrible decision in hindsight—it really wasn’t a good decision in foresight either, as I have argued, but it turned out very badly—yet the accounting impact on ROE makes it seem brilliant. What baloney.
EVA once again glides into the sorry scene to put things right. It reverses the entries that gave rise to the minimum retirement liability. It restores the book equity back to what it was, and reduces the on-balance-sheet liability to what it was. It adds back the reported retirement cost to earnings and subtracts the higher service cost in its place, and reverses the difference out of the retirement liability as if that distortion had not occurred. Then, it glances off book to observe a weakened retirement fund, one that formerly stood toe-to-toe with the pension liability, but which has now shriveled to chest high. EVA realizes it will take nutritional sustenance to restore the fund to its former status. It computes the cost of financing the replenishment at the cost of capital rate, and then deducts the charge from EVA. Now we have the truth. This was a dumb decision with a bad outcome. Now EVA has penetrated the fog of the accounting and made it plain for everyone to see what is really going on. The cost of a retirement plan is the service cost. Funding strategies that deviate from investing in safe, matched-risk bonds are speculation. The market does not pay for speculation, since anyone can do that and hardly anyone wins it. Funding gaps created by actuarial and investment losses are real liabilities, all right, but let’s recognize the liability as a charge to EVA funded at the cost of capital rate. Accounting is a distorted view of an imaginary world. EVA is the truth of the matter. It is the economic reality.
STRATEGIC INVESTMENTS
I define a strategic investment as one that takes a while to ramp up and fully bear fruit, though I do remember a meeting quite a while back with a former CFO of Teledyne who said, “Bennett, I thought strategic investments were the ones that were never going to pay off.” Now that was the voice of experience. But to be fair, strategic investments happen all the time and quite frequently do pay off.
This recalls an assignment I had working for Jollibee Foods in the Philippines. At the time (1998), there were only two markets in the world where McDonald’s did not sell the most fast food. One was Israel because a kosher firm did, and the other was the Philippines for no good reason other than that Tony Tan, a Chinese immigrant entrepreneur and founder of Jollibee, so out-hustled the Golden Arches and so localized the product that his fast-food chain was among the most highly respected of all firms in Southeast Asia. When I met Tony, he said he wanted to put in EVA, and when I had the temerity to ask why he needed it, he responded, “We are excellent because we adopt best practices, and EVA is a best practice.” I was not going to argue with him.
But shortly after the project began he called to cancel it. I asked why. “Because it takes about 18 months for new stores to fully ramp up to expected traffic, and on the start-up we are not earning the cost of capital. My team is telling me EVA will choke our growth.” I told him that depends on how you measure EVA. We sat down and developed a schedule that said for the first 12 months a restaurant is open, it will be charged for only 60 percent of its capital; for the next 12 months, 90 percent; and after that, for 120 percent. In other words, we figured how much capital could be supported in each period to spread out the expected EVA evenly over time, which meant pushing some of the capital from the front end to the back. I call it the “AAMCO adjustment.” You can pay less now, but then you’ve got to pay more later—to preserve the present value of EVA.
Public utilities do this all the time. It may take five years or longer to construct a new electric plant, and in the meantime, the investment is held out of the rate-base capital and the required return on the capital is not charged to the customer. Instead, it accumulates in the capital account until such time as the plant is operational. Then the entire amount, the bricks and mortar and the accumulated interest in the capital account, is folded into the rate base to generate a return. It is a well-established (dare I say it) accounting practice. But my point is that it should not apply just to regulated public utilities.
Georgia-Pacific, for example, used it to meter in the capital invested when major new paper lines were added. Apparently you cannot add a small paper-making line; you can only add them in quantum lumps, and you understand that you always invest a little ahead of the market to stake out your claim. So holding back a portion of the up-front investment and then metering it back into capital according to a preset schedule was a simple adjustment that encouraged the right decisions about timing the investments while maintaining accountability for generating the planned results on time and with interest.
Ball Corporation also provides strategic relief, but in its case it is not so formulaic. A special corporate committee reporting to the CFO reviews capital deferral proposals submitted by the line teams. And it is used sparingly, and only in the most material and truly strategic of applications.
Events that qualify are acquisitions. CFO Scott Morrison explains: “When we make an acquisition we recognize that the price we pay cannot be fully justified by the first year’s earnings. We look to integrate and grow the target, and that typically ramps up over three years. So we figure out how much of the purchase price is due to the value of the expected first-year EVA earnings, and we hold back the rest and meter it into capital over three years. That way, we can get the deals done without a penalty to our EVA, but that way we are all on the hook to deliver the added value over time.”
Here’s an example. Suppose Ball paid 16 times earnings, or $1.6 billion, for a business that was projected to earn a first-year NOPAT of $100 million. To keep it simple, suppose Ball used a 10 percent cost of capital (Ball actually uses 9 percent). Then management would figure that the first-year NOPAT was worth an even $1 billion, and would hold back the $600 million difference and meter it into capital over three years. That way, the first year’s EVA would be zero if NOPAT was on plan. Over the next three years NOPAT would have to increase to cover the cost of any new capital put into the business, as usual, but in addition, it would have to increase by at least another $20 million a year—that’s the 10 percent return on the $200 capital leg in each of the three years—just to remain EVA neutral. Metering the capital back in simulates, and requires, the growth in economic profit that was the basis for justifying the acquisition price in the first place.
Most CFOs understand the issue, but they take a different approach. They don’t adjust the performance measure. Instead, they adjust their performance targets. They swallow hard and acquiesce in setting an initially lower return goal to get a strategic deal done and bring the capital onto their books. The trouble is, once the first year has passed, everyone has conveniently forgotten the rosy forecasts submitted to justify the transaction or the investment in the first place. Going forward, performance targets are renegotiated like any other year in the budget process, with no memory of past promises or any accountability for actually delivering the strategic value. Knowing that there’s a free pass after the first year is up, line teams at most companies are just not as seriously committed to rigorously planning out and delivering deal value as they should be, and that creates an unfortunate tension with CFOs, who care about protecting their company’s financial strength. The interests of the decision makers inside the company are simply not as aligned as they should be when they most need to be—at the time the decision is going to be made.
SIMPLE MEASURES MAKE FOR COMPLEX CONVERSATIONS
There is a larger point here: Simple measures make for complex conversations. Traditional, out-of-the-box, ready-to-eat performance measures do not adapt well to transforming events or one-time items, like restructuring a business, stepping up spending on intangibles, outsourcing decisions, asset sales, consummating a major acquisition, deferring taxes, changing a company’s capital structure, and the like. In consequence, managers and board members must devote a lot of time debating how to adjust the targets for those measures as circumstances change in a delicate and in fact impossible balancing act. But with EVA the target is always the same—more is better than less; bigger is better. EVA incorporates adjustments that smooth out and accommodate life’s little surprises, that better match cost and benefit, that reflect the true strategic cost of capital, and so forth, which is why Ball Corporation could have such a simple and unchanging EVA bonus plan for 20 years.
When people tell me that they are concerned EVA is too complex to understand, I say three things. First, that’s not really true. EVA is just common sense, and it is fundamentally a lot more intuitively appealing to operating people than profit measured by accounting rules. It is basically a three-line calculation—sales less operating costs less the capital costs to rent the balance sheet. True, some of the adjustments we just went through, especially the ones for taxes and defined-benefit pensions, are bewildering. But that is only because it takes a lot of steps to reverse the distortions inherent in reported accounting. Where EVA ends up is actually far easier to understand. As for taxes, it tells operating people to make decisions based on their fundamental underlying tax rate, and to use legitimate means to defer tax. For pensions, EVA says the operating cost is the service cost in the period, and speculative funding gains or losses are isolated as a corporate concern. Those messages are clear and clearly measured with EVA, but not so with reported figures. If anything, EVA brings enlightenment to the dark corners of accounting.
Second, explaining EVA and how to measure it is actually a very good way to get buy-in, to increase business acumen and introduce a common language, and to propel the out-of-the-box thinking that can actually increase EVA. Training is not a challenge; it is an enormous opportunity, as I have said.
Third, life is complex. In the real world a CFO must choose between using a more sophisticated metric like EVA that is defined to measure the value added from period to period and to iron out the bumps, and negotiating targets for a bunch of conventional metrics that don’t accurately measure much of anything and that are subject to jarring distortions. You don’t avoid complexity by using simple standard measures. You are just forced to shift the complexity into debates over how to adjust the targets. I say, keep it simple. Focus on increasing EVA as the measure that matters, and define EVA so that, to the greatest extent practical, a year-over-year increase is a real win, and a decrease is a real loss.
Before concluding this chapter, I want to point out that the corrective adjustments I’ve discussed are value neutral. We insist that any adjustment must alter only the pattern but not the present value of EVA. The present value is the same if a tax deferral flows right into cash taxes or if a capital charge credit for the deferral is added to EVA each year, and is the same if R&D is expensed or if it is amortized over time with cost-of-capital interest added to the unamortized balance. EVA cannot be defined arbitrarily. The present value of EVA and the net present value of free cash flow must be equal, which means that even in the EVA world, debits and credits must still balance. It’s a quality check and an anchor to reality, and something that a lot of CFOs who claim to measure EVA forget to do.
SUMMING UP
Accountants cannot serve multiple masters in one set of financial records. They cannot at the same time address the needs of share owners and business managers who are or should be interested in maximizing going-concern value, and the requirements of lenders who want to write loan covenants against assets recoverable in liquidation, of regulators and politicians who are interested in witch hunts, and, worst of all, misguided CFOs who lobby for rules that enable them to inflate and manage reported profits. As a business manager, CEO, or corporate board member, you simply cannot afford to take reported accounting results at face value. There is way too much cosmetic surgery standing between you and the truth. You’ll be misdirected at every turn. You should use EVA to get under the skin and measure the real economic profit with far more consistency and reliability than whatever comes out of an accounting report.
When I began my business career at the Chase Manhattan Bank in 1976 and went through the management training program, my colleagues and I were taught to rip apart company financials, question every reported line item and footnote, and do everything we could to get to the root of the firm’s cash-flow-generating ability to service our loans. I understood that that was how markets worked, that lenders and shareholders were generally intelligent, trained, financially sophisticated professionals and skeptical people who did not trust surface appearance and who knew how to look well beyond the accounting façade and deeply into the workings of business performance. They—we—didn’t always get that right, but it wasn’t for lack of trying.
Imagine my dismay when I first became a consultant in the late 1970s and went out to meet CFOs and CEOs to discover how many of them assumed that the market would react unthinkingly to their financials at reported face value, and that, in those innocent days, it was actually ethical to manipulate accounting (within the malleable principles, of course) to put the best face on their reported results. I knew from personal experience (plus a lot of evidence on stock market behavior) and Sunday school that that view was totally wrong.
And now that we’ve added an EVA stock rating model to our tool kit (covered at the end of the book), I have had the privilege of meeting with many of the smartest and most influential investors in the world. I can tell you most certainly that none of the ones I’ve met put much, if any, credence in book accounting profits. They are acutely aware of pitfalls such as I have discussed, and they earnestly want to get to the truth, because the truth enables them to make better buy/sell decisions a little ahead of the crowd. Many of them are understandably drawn to EVA for consistently repairing the distortions and making it easier for them to size up how a company is really doing.
To close out this chapter, let me confess that I’ve been rather hard on the accountants, but I do not really mean to be. They are just following the rules and are caught in the middle of a political process. They are doing an admirable job to keep up with all the complexity. And besides, I particularly need the corporate accountants on my side to administer the corporate EVA programs. They are, as often as not, the keepers of the EVA flame. So, sorry, I take it all back. Let’s be friends.