Andrew McElheran
In 2018, shortly after its acquisition of
equity research firm EVA Dimensions, Institutional Shareholder Services (ISS) announced
that it will include Economic Value Added (EVA) measures in advisory reports[1]. ISS
believes EVA measures provide a clear and more complete picture of value
creation.
The challenge for financial companies is
that EVA is a difficult metric to apply, since these companies have capital
structures and business models that make calculation of EVA problematic. As a
result, despite ISS’s view to the contrary, the metric is typically not viewed as
relevant for financial companies, as discussed below.
Economic Value Added – A Primer
EVA is
fundamentally a profitability metric. It is the best-known version of a class
of financial performance measures known as economic profit models. Distinct
from accounting profit, economic profit/EVA is profitability after one
additional charge—the cost of the capital employed to attain those profits. The
idea behind EVA is that capital is not free, and companies that earn a return
on that capital in excess of its opportunity cost are the only ones actually
creating value.
At its
simplest, EVA (or any economic profit calculation) is defined by three building
blocks:
NOPAT – (Capital × Cost of Capital)
Where…
- “NOPAT” (Net Operating Profit After-Tax) is essentially, operating
income, less taxes on that income. For financial companies, ISS will define
this as net income (thus deducting interest expense and treating it as an
operating cost). - “Capital”
is defined as total assets less non-interest bearing current liabilities
(sometimes also referred to as “net assets” or “capital employed”). For
financial firms, ISS is defining “capital” solely
as equity capital (as adjusted). - Cost
of Capital” refers to the required or minimum return on capital an
investor expects over time for investing in a company of particular risk. For financial
companies, ISS will (presumably) define this as cost of equity only, to match
to the definition of “capital” used. The products offered by financial
companies are inextricably interwoven with their capital structures and
consequently debt (deposits) and loans (assets) are central to their business
model and debt is excluded from the cost of capital calculation.
ISS is providing four EVA metrics in its reports. Two metrics are “static” and are similar to net income margin and a version of return on equity (ROE). The other two metrics are “trend” measures, evaluating the growth in EVA relative to revenues and equity capital. For additional background, including detailed formulas for the four EVA metrics that ISS will use, refer to Meridian’s April 2019 Client Alert.
Challenges with EVA in the Financial
Services Industry
Most companies in the financial services
industry already have an intimate understanding of their economic profits, measured
as earnings spreads against their own definitions of economic capital. This
understanding differentiates financial companies from companies in other, more
capital-intensive industries, which may not focus on economic value. In other
words, while the concept of cost of capital may be new for companies in other
industries, in the financial services industry it is already reflected in internal calculations (and planning efforts),
in a more accurate manner.
Financial companies use precise “bottoms-up”
adjustments to internal metrics – potentially incorporating non-public data – to
calculate economic value (examples include variations of ROE metrics). We think
EVA is likely to be far less relevant in the financial services industry given ISS’s
reliance on only public GAAP data. ISS’s attempt to customize EVA for financial
companies adds complexity to the already often misunderstood metric and is
likely to only add confusion for investors looking to track
pay-for-performance.
Using EVA as a
performance measure in the financial services industry could also have
unintended consequences. Financial companies borrow funds at one interest rate
and provide loans at a different, higher rate. The resulting “net revenue”
takes into account both the interest earned on assets over time (“gross
revenue”) as well as interest paid on deposits (i.e., a deduction from gross revenue).
The spread is greatly impacted by prevailing interest rate levels in the
economy. To maximize EVA, management teams could take on unplanned risks or
pursue non-core activities in the name of increasing EVA. Although this may
apply to any metric, to some degree the risk may be more acute with EVA because
the metric incorporates many layers of assumptions, some of which are not
specific to a company’s unique situation.
An additional consideration
is that for financial companies invariably there is a lag between value-added
growth investments and achieving a higher EVA (i.e., returns > cost of
capital). While this is true for all industries, for financial companies these
lags can be considerable due to the time required for new assets to reach their
anticipated profit potential. Consequently, EVA (like any financial metric) is
not immune to distortions and incomplete understanding, without a wider
strategic view of a company’s business.
Takeaways
Although measuring EVA can
be valuable for companies in many industries, companies in the financial
services industry typically gain limited insight from the metric. For financial
companies, similar (and more meaningful) information can be gained through alternative
and more accurate metrics. Based on our understanding to date, ISS will likely continue
in its efforts to incorporate EVA into quantitative performance analyses
despite its flaws. In our discussions with the proxy advisor, ISS has indicated
that the metric will provide a reference or serve as a “signal” for assessing
performance and does not expect companies to incorporate EVA in their incentive
programs. Although incentive plans and compensation practices will not be directly
affected, Boards, investors and senior management of financial companies will
need to pay attention to ISS’s use of EVA and consider the implications it may
have on the proxy advisor’s Say on Pay reviews and recommendations.
Importantly, financial companies may consider providing feedback in ISS’s
Annual Policy Survey in order to give the proxy advisor additional perspective
on the use of EVA in the financial services industry.
[1] In 2019, ISS
included EVA data in its reports for informational purposes, but has indicated
that they may include it in their quantitative pay-for-performance tests in the
future