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In many companies the all-important quest for value is being confounded by a hopelessly obsolete financial management system. The wrong financial goals, performance measures, and valuation procedures are emphasized. Managers are improperly and in many cases inadequately rewarded for their efforts. Balance sheets are but dully structured when surgical sharpness often is needed. These shortcomings cry out for approaches to financial management so profoundly different from current ones that nothing less than a revolution in thinking is called for.

Abandon Earnings Per Share

First of all, the myth that increasing earnings, earnings per share, or return on equity is the way to attract Wall Street must be abandoned. Many senior executives believe that the market wants earnings, and wants them now, despite the fact that not one shred of convincing evidence to substantiate that outlandish claim has ever been produced. To satisfy Wall Street's alleged craving for reported profits, many top managers feel compelled to conjure up earnings through time-consuming and ethics-corroding accounting legerdemain. Expenses that should be deducted to save taxes are deferred. Valuable acquisitions are avoided if a large amount of goodwill must be amortized. R&D and market-building outlays get short shrift. The execution of dying businesses is postponed. And perhaps worst of all, lusty earnings growth is sustained by overinvesting in mature businesses.

Arrayed against the earnings myth and these harmful practices is an overwhelming body of established academic research. It shows that accounting measures of performance are only coincidentally related to stock prices and are not the primary movers and shakers. What truly determines stock prices, the evidence proves, is the cash, adjusted for time and risk, that investors can expect to get back over the life of the business. What the market wants is not earnings now, but value now. The question is: How can discounted cash flow, which truly is at the heart of market valuation, become the driving and integrating force behind the financial management system?

Economic Value Added: A True

Measure of Corporate Success

The answer, for the most part, is actually quite straightforward: Management should focus on maximizing a measure called eco-nomic value added (EVA), which is operating profits less the cost of all of the capital employed to produce those earnings. EVA will increase if operating profits can be made to grow without tying up any more capital, if new capital can be invested in projects that will earn more than the full cost of the capital and if capital can be diverted or liquidated from business activities that do not provide adequate returns. It will be reduced if management fritters away funds on projects that earn less than the cost of capital or passes over projects likely to earn more than the cost of capital. It just so happens that EVA is the only performance measure that is entirely consistent with the standard capital budgeting rule: Accept all positive and reject all negative net present value investments. (Earnings per share, on the other hand, will increase so long as new capital investments earn anything more than the after-tax cost of borrowing, which is hardly an acceptable re-turn.)

The most important reason to adopt EVA as the main corporate financial goal, however, is that it is the only measure to tie directly to intrinsic market value. Discounting the EVA to be generated by an individual capital project, for instance, automatically results in its net present value. (The cost of the new capital employed to finance the project is explicitly subtracted in the very calculation of EVA.) The capital budgeting prescription to accept positive NPV projects can be restated as follows: Accept all investment opportunities which will produce a positive discounted EVA. It is one and the same thing.

Carrying this concept to a higher level, projecting and discounting EVA for an entire company automatically sums the net present value of all of the firm's past and projected capital investement projects. The sum accounts for the company s market value premium to capital employed (which is simply the total of all investments the company has made to date). A company forwhich projected EVA discounts to, say, $100 million, and which currently employs $500 million of capital, has an intrinsic market value of $600 million. This relation tells us that if its EVA is expected to be positive, a company has added value to the out-of-pocket cost of the resources drawn into the firm; if EVA is projected to be negative, value has been destroyed. EVA, in short, is the fuel that fires up a premium in the stock market value of any company or accounts for its discount.

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Excerpted from The Quest for Value by G. Bennett Stewart Copyright © 2003 by G. Bennett Stewart
Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.