Alpha Corporation

Developing Successful EVA®-Based Incentives

Copyright © December 11, 1997

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.

Measuring Corporate Success:

The Ultimate Financial Test

A high stock price? Marketcapitalization?

Rapid stock priceappreciation? !

A large and growing market premium to book value?

TotalMarketValue

Cost ofInvestedCapital

The MVA Scorecard

MVA Winners

Coca-Cola $124.1 Microsoft 83.3 Intel 85.0 Merck 72.5 Phillip Morris 59.8 Proctor & Gamble 54.5 Exxon 51.5 Johnson & Johnson 48.8 Chase Manhattan 43.7 Pfizer 40.8

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 $134.5Capital Invested 10.4MVA $124.1

5-Year XVA $73.1

Total Market Value $135.5Capital Invested 187.9MVA ($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.

How do you drive MVA?

MVA comes from operations, not finance. MVA depends on the future, not the past.

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.

Reconciling Value Drivers

Avoid Mixed Signals

Corporate Office

InvestorRelations

CapitalBudgeting

HumanResources

StrategicPlanning

CostAccounting

TreasuryManagement

DiscountedCash Flow

ROE and NetIncome

Market Share,Earnings Growth

EPS

Asset Turns

Cash Flow

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.

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.

StrategicPlanning

InvestorRelations

CapitalBudgeting

HumanResources

CostAccounting

TreasuryManagement

AnnualBudgeting

Valuation

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.

StrategicPlanning

InvestorRelations

CapitalBudgeting

HumanResources

CostAccounting

TreasuryManagement

AnnualBudgeting

Valuation

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 Capitalx Beg. Capital

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.

Value Proposition: EVA Drives MVA

PV CF1

Value

PV CF3

PV CF2

PV

NOPATC

Discounted Free Cash Flow

Capital

Discounted Economic Value Added

PV EVA1

PV EVA2

PV EVA3

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.

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

Linking pay decisively to EVA

Why are incentives so important?

Strategy: Use performance-based pay to attract top talent and and encourage value creation

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

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.

Value-based plans, in contrast, clearly link decisions, results and shareholder value.

The traditional annual incentive plan

Target

$ Bonus

OperatingProfit

Budget80% 120%

The EVA-based incentive plan

Target

$ Bonus

EVA

PerformanceTarget

Deferred “at risk”portion of award

Key Features:

No caps (or floors)

A bonus “bank”

Self-adjustingtargets

Greater leverage

The EVA-based incentive plan: Target-Setting

Target

$ Bonus

EVA

PerformanceTarget

Key Features:

No caps (or floors)

A bonus “bank”

Self-adjustingtargets

Greater leverage

Targets can reflect: Uniform improvement

level Peer performance Market expectations

Targets can reflect: Uniform improvement

level Peer performance Market expectations

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

$100Capital

MVA EVA C

$ 30

PV EVAPV EVA

PV EVA

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.

EVA Implementation Process

Understandand

appreciatecurrent

readiness for change

Understandand

appreciatecurrent

readiness for change

Determinestrategy

(objectives,messages,and media)

Determinestrategy

(objectives,messages,and media)

Developtraining/

communicationmaterials

Developtraining/

communicationmaterials

RolloutRollout EvaluateResults

EvaluateResults

Step 1 Step 2 Step 3 Step 4 Step 5

Framework Example: A Major Oil & Gas Company

Operating Profit Operating Profit

DistillateOperating

Profit

DistillateOperating

Profit

Car WashOperating

Profit

Car WashOperating

Profit

ConvenienceStore Oper.

Profit

ConvenienceStore Oper.

Profit

LubricantsOperating

Profit

LubricantsOperating

Profit

GasolineOperating

Profit

GasolineOperating

Profit

GasolineOperatingProfit

GasolineOperatingProfit

Product MarginProduct Margin Total CostsTotal Costs

Variable CostsVariable Costs Period CostsPeriod Costs

Product MarginProduct Margin

VolumeVolume Weighted MarginWeighted MarginVolumeVolume Weighted MarginWeighted MarginVolumeVolume

RetainedAccounts

RetainedAccounts

NewAccounts

NewAccounts

Grade RatioGrade Ratio

Grade MarginGrade Margin

Weighted MarginWeighted Margin

Grade RatioGrade Ratio

Grade MarginGrade Margin

Grade RatioGrade Ratio

Mid-GradeMid-Grade

PremiumPremium

RegularRegular

Framework Example: A Major Oil & Gas Company

Operating Profit Operating Profit

DistillateOperating

Profit

DistillateOperating

Profit

Car WashOperating

Profit

Car WashOperating

Profit

ConvenienceStore Oper.

Profit

ConvenienceStore Oper.

Profit

LubricantsOperating

Profit

LubricantsOperating

Profit

GasolineOperating

Profit

GasolineOperating

Profit

GasolineOperatingProfit

GasolineOperatingProfit

Product MarginProduct Margin Total CostsTotal Costs

Variable CostsVariable Costs Period CostsPeriod Costs

Product MarginProduct Margin

VolumeVolume Weighted MarginWeighted MarginVolumeVolume Weighted MarginWeighted MarginVolumeVolume

RetainedAccounts

RetainedAccounts

NewAccounts

NewAccounts

Grade RatioGrade Ratio

Grade MarginGrade Margin

Weighted MarginWeighted Margin

Grade RatioGrade Ratio

Mid-GradeMid-Grade

PremiumPremium

RegularRegular

Grade MarginGrade Margin

Mid-GradeMid-Grade

PremiumPremium

RegularRegular

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:

High Impact Medium Impact Low Impact

Legend:

High Impact Medium Impact Low Impact

Volume

Cost of Goods Sold

SG&A

Cost of Debt

Cost of Equity

Fixed Capital

Working Capital

Other

Price

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.

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.