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Alpha Corporation Developing Successful EVA ® - Based Incentives Copyright © December 11, 1997.

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Presentation on theme: "Alpha Corporation Developing Successful EVA ® - Based Incentives Copyright © December 11, 1997."— Presentation transcript:

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2 Alpha Corporation Developing Successful EVA ® - Based Incentives Copyright © December 11, 1997

3 Three Stages of EVA ® Implementation * Building EVA awareness * Linking pay decisively to EVA * Developing EVA-based action steps for line managers. EVA is a registered trademark of Stern Stewart & Co. The directors of Finegan & Gressle are former partners and officers of Stern Stewart who contributed significantly to developing and popularizing EVA.

4 Measuring Corporate Success: The Ultimate Financial Test * A high stock price? * Market capitalization? * Rapid stock price appreciation? ! * A large and growing market premium to book value? Total Market Value Cost of Invested Capital

5 The MVA Scorecard MVA Winners * Coca-Cola$124.1 * Microsoft83.3 * Intel85.0 * Merck72.5 * Phillip Morris59.8 * Proctor & Gamble54.5 * Exxon51.5 * Johnson & Johnson48.8 * Chase Manhattan43.7 * Pfizer40.8 MVA Losers * ITT($77.1) * General Motors(52.4) * Loews(46.4) * American Express(36.7) * Ford Motor Company(34.0) * Travelers Group(19.5) * RJR Nabisco(14.4) * PG&E(7.0) * Phillips Electronics(6.4) * Digital Equipment(6.0) Source:Finegan & Gressle survey of the 1,700 largest companies traded on a U.S. exchange based on year-end 1996 data ($ Billions). A complete listing is available at www.shareholdervalue.com. Total Market Value$134.5 Capital Invested10.4 MVA$124.1 5-Year XVA$73.1 Total Market Value$135.5 Capital Invested187.9 MVA($52.4) 5-Year XVA($83.2) The Point:Coke and GM have identical trading values, but GM invested $200 billion more than Coke to get there. During the last 5 years alone, Coke generated $73 billion more in value than could have been expected from the market in general. By contrast, GM destroyed $83 billion. The Point:Coke and GM have identical trading values, but GM invested $200 billion more than Coke to get there. During the last 5 years alone, Coke generated $73 billion more in value than could have been expected from the market in general. By contrast, GM destroyed $83 billion.

6 How do you drive MVA? * MVA comes from operations, not finance. * MVA depends on the future, not the past.

7 How do you drive MVA? * MVA comes from operations, not finance. * MVA depends on the future, not the past. The Performance Measurement Challenge * Reconcile the discrete and often conflicting value drivers of a business. * Differentiate substantive economic performance from bookkeeping entries. * Capture the real time cost of money.

8 Reconciling Value Drivers Avoid Mixed Signals * The Traditional Financial Management System * No common denominator of value. * Heavily dependent on corporate synthesis and reconciliation of departmental figures. * Information transfers slow and inefficient.

9 Reconciling Value Drivers Avoid Mixed Signals * The Traditional Financial Management System * No common denominator of value. * Heavily dependent on corporate synthesis and reconciliation of departmental figures. * Information transfers slow and inefficient. * The Ideal Financial Management System * Common language for allocating resources, conducting valuations, measuring performance, and communicating with investors. * Minimal corporate synthesis and reconciliation. * Information transfers real-time and meaningful.

10 Reconciling Value Drivers Avoid Mixed Signals * The Traditional Financial Management System * No common denominator of value. * Heavily dependent on corporate synthesis and reconciliation of departmental figures. * Information transfers slow and inefficient. * The Ideal Financial Management System * Common language for allocating resources, conducting valuations, measuring performance, and communicating with investors. * Minimal corporate synthesis and reconciliation. * Information transfers real-time and meaningful.

11 EVA = Operating Profit - Opportunity Cost of Running the Business An Integrated Measure of Business Performance Sales – Cost of Sales – Overhead EBIT – Tax on Operations NOPAT Cost of Borrowing? Dividend Yield? The return (or expectation) foregone by not investing in a comparably risky portfolio of projects—the weighted cost of debt and equity capital. Opp. Cost = Cost of Capital x Beg. Capital

12 EVA = NOPAT - c* x Beg. Capital An Integrated Measure of Business Performance EVA can also be expressed as: EVA = (Return on Capital - Cost of Capital) x Beg. Capital EVA introduces four powerful incentives: * Improve efficiency, and thus returns. * Grow, but only if new investments can earn the cost of capital. * Redeploy capital from underperforming operations. * Manage risk, and therefore the cost of capital.

13 Value Proposition: EVA Drives MVA PV CF 1 Value PV CF 3 PV CF 2 PV NOPAT C Discounted Free Cash Flow Capital Discounted Economic Value Added PV EVA 1 PV EVA 2 PV EVA 3 PV EVA C Value MVA  The discounted present value of a company’s expected EVA is its market value premium or discount to book value (“MVA”).  A company’s discounted EVA plus its level of capital employed will always equal the discounted present value of expected Free Cash Flow.  EVA is the only integrated measure of growth and profitability which relates directly to stock value.

14 Measurement Challenges: * Differentiate substantive performance from bookkeeping:  Acquisition accounting  Write-offs and restructuring charges  Off balance-sheet financing  Expensing of long-term investments * Capture the real cost of money:  Cash-basis versus accrual accounting

15 Linking pay decisively to EVA Why are incentives so important? Strategy:Use performance-based pay to attract top talent and and encourage value creation Executive Talent * Decisive edge in value creation * Highly sought Executive Talent * Decisive edge in value creation * Highly sought Pressure on Performance * Tremendous opportunities * Fewer competitive barriers * Accelerating change * Rapid competitive response * Investor pressure Pressure on Performance * Tremendous opportunities * Fewer competitive barriers * Accelerating change * Rapid competitive response * Investor pressure

16 The Reality: Most incentive plans aren’t designed to drive value creation Stock and Options * Linked to stock price * Competitive * Line of sight often poor * No focus on goals Stock and Options * Linked to stock price * Competitive * Line of sight often poor * No focus on goals Cash Incentives * Mainly annual * EPS, ROE goals, capped * Weak link to value * Battles over fairness Cash Incentives * Mainly annual * EPS, ROE goals, capped * Weak link to value * Battles over fairness * Value-based plans, in contrast, clearly link decisions, results and shareholder value.

17 The traditional annual incentive plan Target $ Bonus Operating Profit Budget 80%120%

18 The EVA-based incentive plan Target $ Bonus EVA Performance Target Deferred “at risk” portion of award Key Features: * No caps (or floors) * A bonus “bank” * Self-adjusting targets * Greater leverage

19 The EVA-based incentive plan:Target-Setting Target $ Bonus EVA Performance Target Key Features: * No caps (or floors) * A bonus “bank” * Self-adjusting targets * Greater leverage Targets can reflect: * Uniform improvement level * Peer performance * Market expectations Targets can reflect: * Uniform improvement level * Peer performance * Market expectations

20 The EVA-based incentive plan:Target-Setting The expected annual improvement in EVA can be determined from market expectations: Present Value of EVA Improvement Current EVA Capitalized $ 50 $80 $100 Capital MVA EVA C $ 30 PV EVA

21 Long-Term Incentive -- Example I Corporate * European * Multiple lines of business * Bonus based upon corporate economic profit Business Unit * American * Single line of business * Global competition * Weak link to UK share price * Performance units/shares and bonus based upon unit EVA Performance Metric NOPAT - c* x C = EVA Terms Three-year vesting 50/50 cash/stock

22 Long-Term Incentive -- Example II Corporate * Multi-unit service business * Phantom stock (private co.) * Corporate value (TBR) * Formula-driven Business Unit * Diverse units * Balance of unit focus and corporate-wide teamwork * Phantom stock * Corporate and business unit grants Performance Metric 1)V=C + (NOPAT - c* x C)/c* V=enterprise value based upon current results C=Capital c*=Cost of capital 2)TBR 1 =V 1 - V 0 + D 1 D=Net dividends TBR=Total Business Return Terms * Three-year vesting * Six-year term

23 Effective EVA Implementation Requires: * Management recognition that current financial measures distort capital allocation or weaken incentives to create shareholder value. * Understanding and appreciation by Operations, Human Resources and Finance of EVA’s role in effecting change. * Sufficient investment of time and resources to help managers understand what EVA is and how it should be used in managing their business.

24 EVA Implementation Process Understand and appreciate current readiness for change Understand and appreciate current readiness for change Determine strategy (objectives, messages, and media) Determine strategy (objectives, messages, and media) Develop training/ communication materials Develop training/ communication materials Rollout Evaluate Results Evaluate Results Step 1Step 2Step 3Step 4Step 5

25 Framework Example: A Major Oil & Gas Company Operating Profit Distillate Operating Profit Car Wash Operating Profit Convenience Store Oper. Profit Lubricants Operating Profit Gasoline Operating Profit

26 Framework Example: A Major Oil & Gas Company Operating Profit Distillate Operating Profit Car Wash Operating Profit Convenience Store Oper. Profit Lubricants Operating Profit Gasoline Operating Profit Product Margin Total Costs Product Margin Total Costs Variable Costs Period Costs

27 Framework Example: A Major Oil & Gas Company Operating Profit Distillate Operating Profit Car Wash Operating Profit Convenience Store Oper. Profit Lubricants Operating Profit Gasoline Operating Profit Product Margin Total Costs Variable Costs Period Costs Product Margin Volume Weighted Margin Volume Weighted Margin Volume Retained Accounts New Accounts

28 Framework Example: A Major Oil & Gas Company Operating Profit Distillate Operating Profit Car Wash Operating Profit Convenience Store Oper. Profit Lubricants Operating Profit Gasoline Operating Profit Product Margin Total Costs Variable Costs Period Costs Product Margin Volume Weighted Margin Volume Weighted Margin Volume Retained Accounts New Accounts Grade Ratio Grade Margin Weighted Margin Grade Ratio Grade Margin Grade Ratio Mid-Grade Premium Regular

29 Framework Example: A Major Oil & Gas Company Operating Profit Distillate Operating Profit Car Wash Operating Profit Convenience Store Oper. Profit Lubricants Operating Profit Gasoline Operating Profit Product Margin Total Costs Variable Costs Period Costs Product Margin Volume Weighted Margin Volume Weighted Margin Volume Retained Accounts New Accounts Grade Ratio Grade Margin Weighted Margin Grade Ratio Mid-Grade Premium Regular Grade Margin Mid-Grade Premium Regular

30 Improved Implementation: Making performance measures “line-of-sight” Raw Materials Labor Other Plant & Equipment Property Inventory Receivables Payables Good Will Intangibles Revenue Tax Operating Expenses Cost of Capital Capital Employed Capital Charge NOPAT EVA Legend: n High Impact n Medium Impact n Low Impact Volume Cost of Goods Sold SG&A Cost of Debt Cost of Equity Fixed Capital Working Capital Other Price

31 Common Concerns: * We have too many initiatives already underway; this will just confuse everyone. * It’s too complicated; nobody will understand it. * We’re already very successful, so why do we need this? * I’m investing for the future, but you’re measuring today’s returns. * You can’t compare my SBU to SBU X, we’re different. * We should formulate our strategy first and decide where we’re trying to go before we start measuring performance. * We just convinced everyone that Return on Capital is the most important measure to evaluate performance.

32 EVA Implementation “If I had to do it over…” * “Keep it simple!” * Devote greater resources to improving financial literacy. * Establish clear “line-of-sight” between a manager’s actions and EVA, and EVA and shareholder value. * Integrate the EVA initiative with other efforts such as cycle time, customer satisfaction, and balanced scorecard. * Develop “EVA Coaches” to provide continuing support. * Gain early “buy-in” from operations.

33 The End

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