But now it had been realised LB is "dead meat" because managing for ROE seemed to allow financial staff to overborrow; after all, debt looks to be capital that earns a return (in good times). Yet it isn't equity, so extreme leverage simply juices ROE until bad times arrive. Their staff had wished for the wrong thing, managing for the wrong ratio and eventually busted the reputable and renowned company.
The chilling fact is that every other ratio out there can lead to the same disaster. Gross margin? Earnings per share? It's easy to make any of them look better while damaging the corporate financial banking and business.
Which is why corporations nowadays swing to a new concept and theory ratio, i.e. EVA and is maybe intriguing but needs more in-depth knowledge on this terminology. It has been developed by consultant Bennett Stewart, one of the creators of the financial measure called economic value added, or EVA. [ Our company uses it partly to retained "valuable staff" with lump sum payout yearly,i.e. if company is in the black. It is one of the useful retention tool, apart from others like, share options, bonuses, good career path, promotions, etc ]
Now many firms use this term, including Siemens, Best Buy (BBY, Fortune 500), and Herman Miller (MLHR), EVA is essentially profit after deducting an appropriate charge for all the capital in the business. Because it accounts for all capital costs, its proponents say, EVA is the best measure of value creation.
Now Stewart is making a bold claim about his latest idea: EVA momentum, he says, is the one ratio that can't be manipulated. "It's the only percent metric where more is always better than less," he says. "It always increases when managers do things that make economic sense." If he's right, it is worth knowing about -- for managers at every level and for investors.
EVA momentum idea
It's the change in a business's EVA divided by the prior period's sales. So if a company increases its EVA by $10 million and the prior period's sales were $1 billion, then its EVA momentum is 1%. That's not bad, considering that for most companies this figure is zero or negative, and the average for many companies is generally around zero.
The key insight is that achieving high EVA momentum requires a business to do two difficult things at once. It must grow while at the same time maintaining healthy EVA profit margins or improving poor ones.
Can this ratio be gamed?
It's hard to see how. A popular gambit of conniving managers is to shrink a ratio's denominator recklessly, which is what Lehman executives did when they cut the E in ROE dangerously low. But the denominator in EVA momentum is the last period's sales, so it's fixed going in. Relentlessly jacking up EVA -- the numerator -- is difficult; a proper calculation of EVA values spending on R&D and employee/staff skill and knowledge training, those long-term investments that help companies over time.
EVA momentum is quite a new concept or idea mooded to measure hundreds of companies however real businesses have yet to apply it. What will happen when this ratio confronts actual managers trying to make actual profits. But when a big new idea comes along, adopting it first creates a major advantage. This could be one of those times.
EVA momentum getting it right
1. Don't obsess about sales or profit margins. Managers fixate on how to increase their company's revenues, but if it doesn't boost EVA, it does nothing to create value.
2. Bail out of EVA-negative businesses. Ford's sale of capital-intensive, EVA-sapping Jaguar and Land Rover shrank the company, but in the end increased its value.
3. Annihilate wasted capital. Cutting working capital, as Wal-Mart (WMT, Fortune 500) did in 2009, and offloading unproductive assets are great opportunities to build EVA when growth is slow
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