Why Eva Bonus Plans Failed—And How to Revive Them

10 Pages Posted: 27 May 2020

Date Written: Summer 2019

Abstract

Most companies rely heavily on earnings to measure their financial performance, but earnings growth has at least two important weaknesses as a proxy for investor wealth. Current earnings growth may come at the expense of future earnings through, say, shortsighted cutbacks in corporate investment, including R&D or advertising. But growth in earnings per share can also be achieved by “overinvesting”—that is, committing ever more capital to projects with expected rates of return that, although well below the cost of capital, exceed the after‐tax cost of debt. Stock compensation has been the conventional solution to the first problem because it's a discounted cash flow value that is assumed to discourage actions that sacrifice future earnings. Economic profit—in its most popular manifestation, EVA—has been the conventional solution to the second problem because it includes a capital charge that penalizes low‐return investment. But neither of these conventional solutions appears to work very well in practice. Stock compensation isn't tied to business unit performance, and often fails to motivate corporate managers who believe that meeting consensus earnings is more important than investing to maintain future earnings. EVA often doesn't work well because increases in current EVA often come with reduced expectations of future EVA improvement—and reductions in current EVA are often accompanied by increases in future growth values. Since EVA bonus plans reward current EVA increases without taking account of changes in expected future growth values, they have the potential to encourage margin improvement that comes at the expense of business growth and discourage positive‐NPV investments that, because of longer‐run payoffs, reduce current EVA. In this article, the author demonstrates the possibility of overcoming such short‐termism by developing an operating model of changes in future growth value that can be used to calibrate “dynamic” EVA improvement targets that more closely align EVA bonus plan payouts with investors’ excess returns. With the use of “dynamic” targets, margin improvements that come at the expense of business growth can be discouraged by raising EVA performance targets, while growth investments can be encouraged by the use of lower EVA targets.

Suggested Citation

O'Byrne, Stephen F., Why Eva Bonus Plans Failed—And How to Revive Them (Summer 2019). Journal of Applied Corporate Finance, Vol. 31, Issue 3, pp. 131-138, 2019, Available at SSRN: https://ssrn.com/abstract=3604439 or http://dx.doi.org/10.1111/jacf.12368

Stephen F. O'Byrne (Contact Author)

Shareholder Value Advisors, Inc. ( email )

1865 Palmer Avenue, Suite 210
Larchmont, NY 10538
United States
914-833-5891 (Phone)
914-833-5892 (Fax)

HOME PAGE: http://www.valueadvisors.com/Contact.htm

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