How's Your EVA?

How's Your EVA?

Fortune magazine calls EVA--economic value added--today's hottest financial idea and the one most likely to get even hotter. G. Bennett Stewart III of Stern Stewart and Co. has provided a bible for those seeking to understand and benefit from this new concept: The Quest for Value (Harper Business Books, New York, 1995). Simply stated, EVA is the operating profit of an enterprise less the cost of all the capital employed to produce those earnings. A formula for the EVA of a professional office might look like this:

People can grasp this concept easily, but they don't implement it so easily. According to Peter Drucker, very few Fortune 500 companies have actually added value to their enterprises over the past 50 years.

Striving to add value encourages managers to direct scarce resources to their most promising uses and, thus, effect a more robust economic growth nationwide, with a concomitant improvement in the standard of living. Stewart cites the role of EVA in many well-known business successes and failures, challenging such cherished beliefs as "highly leveraged debt is bad", "big dividends are good", and "price-to-earnings ratio is important in determining the value of a company". By using EVA goals, companies such as Gillette, Wal-Mart, Coca-Cola, and Pepsi have continued to make spectacular gains year after year. In fact, Warren Buffett and other investment gurus use EVA to evaluate the potential of companies before recommending them.

Apart from helping in financial planning and investment strategy, the concept of EVA offers orthodontists a new and perhaps more accurate method of evaluating and improving their managerial ability. There are many ways to create value, but they are all governed by one of three principles:

1. Value will increase when operating profits grow without tying up additional capital. This technique appeals to the frugal-minded, and I've known some orthodontists who have exploited this principle to maximum advantage. Nevertheless, it carries a great risk of driving people, equipment, and facilities beyond their capabilities. Simply trying to do the same things with the same resources--only faster--guarantees a quick burnout of both personnel and equipment. Although this first principle is appealing in that it does not require additional investment, it may, in the end, be the most demanding of all, because it calls for nothing less than a complete managerial overhaul.

2. Value will increase when the company invests in projects that earn more than the cost of capital. This principle requires a professional to thoroughly evaluate any expansion or redesign of facilities, purchase of new equipment, or change in treatment techniques. Most of the time, orthodontists expand the office, buy a new machine, or adopt a new technique with little more than an optimistic expectation that it may help them. While it may be necessary to estimate the increase in efficiency provided by such an expenditure, the cost of capital can be determined exactly. This at least offers some numbers with which to supplement one's intuition about the possible success of a new satellite office, tomograph, or bracket and band system.

3. Value will increase when capital is diverted or liquidated from business activities that do not cover the cost of capital. Computers can help measure the costs of specific orthodontic services, but few software programs offer timing mechanisms that allow us to know the cost in time, as well as in personnel and materials, for delivering a particular treatment to a particular patient. After considering the true cost and yield per patient, an orthodontist might well decide to eliminate or drastically modify such marginal therapies as lingual orthodontics or TMD, or to close a marginal satellite office. Profitability undoubtedly varies from doctor to doctor, but most orthodontists don't presently have enough information to know whether their treatment choices create or destroy value in their practices.

The Quest for Value is not a book you will want to curl up with before an open fire. Its appeal lies in the author's ability to challenge outdated management concepts and to teach us the financial skills and strategies used by the world's best companies.