In board rooms across the country, shareholder value is increasingly becoming the directors’ mantra. Shareholders clamor for increased returns and improved performance. Yet the creation of shareholder value has vastly different implications for the firm in financial distress than for the healthy, growing enterprise. The relevance to various stakeholders and differing capital providers takes on new meaning when the firm is having difficulty meeting its payroll or is overdue on its payments to suppliers.

Firms, advisors and analysts have long sought to measure improved company performance. Such improvement is typically assessed by a wide array of measures, the most common of which are earnings, earnings per share (EPS), return on assets (ROA) and return on equity (ROE). Each of these represents a proxy for value creation.

Yet, for firms in distress, each measure provides potentially misleading information. Consider a convenience store chain that had a loss of $2.5 million last quarter and earned $.5 million this quarter. Has value been created and performance improved? The question must be asked for each capital provider since value is not spread equally among all of the firm’s sources of capital. What may seem like positive news for shareholders may be negative news for creditors and vice versa. In improving its earnings, the convenience store chain deployed $4 million in long overdue capital expenditures (CAPEX) and made $3 million of necessary commitments to increased working capital. The CAPEX and working capital expenditures were necessary to nurture the firm back to operating health. Yet the firm’s short-term financial risk may well have increased with these sizable, but necessary, cash outflows. From the shareholders’ perspective, the risk entailed in making CAPEX and working capital expenditures are compensated for by the long run returns likely to be obtained. The creditors, however, are likely to be concerned that the firm’s cash position will not be sufficient to meet its debts as they come due. The creditors do not have the upside potential enjoyed by the shareholders. Their primary concern is the firm’s ability to repay its debts, not long-run growth or value creation. Thus, in such a distress situation, earnings provide only partial information on performance. Since the firm’s cash position may differ dramatically from its earnings, earnings are clearly a less-than-satisfactory measure for all security holders of the distressed firm.

Even for equity holders, an earnings measure has several major shortcomings. It is an accounting concept that juxta-poses historical values such as depre-ciation, past costs and accruals with the firm’s current rev-enues and costs. And it ignores the important consideration of risk. Two companies having identical earnings may reflect dramatically different degrees of value creation due to sizable risk differences of the enterprises. The earnings may not be sufficiently high to compensate the shareholders of one of the firms for the significant operating risk undertaken, while the same dollar earnings may be more than satisfactory for the shareholders of the second, less risky enterprise.

Interestingly, none of the traditional value creation measures (earnings, EPS, ROA and ROE) meets the needs of the distressed firm. None satisfies the needs of both debt and equity holders. None is cash-based. All ignore the timing of both costs and benefits, thus ignoring the full impact on the firm’s security holders.

Enter the newest of corporate America’s performance measures: economic value added (EVA). While it was applied in the 1920s by General Motors, it was forgotten until the 1980s when Stern Stewart, a New York-based consulting firm, resurrected the measure and proceeded to have it trademarked.

There are numerous benefits to the use of EVA. Primary among its advantages over traditional performance measures is that it explicitly assesses a cost of employing capital. In other words, as the typical firm increases earnings, it also increases its capital employed. This capital, usually in the form of property, plant and equipment and working capital, has a cost. While most performance measures do not explicitly take this cost into account, EVA is directly affected.

Calculation of Economic Value Added
Economic Value Added =
Net Operating Profit After Taxes
(NOPAT) - (Cost of Capital x Capital Employed)

EVA is the after-tax net operating profit (NOPAT) less the cost of capital employed by the business unit or firm in generating that profit. In other words, capital is assessed a charge, a cost; the more capital that is employed, the lower the firm’s EVA.

Although EVA is conceptually quite simple, applying it successfully is sometimes troublesome. Its developers, including Bennett Stewart, point to 164 potential accounting adjustments that are necessary to obtain an accurate reflection of company performance. This suggests obtaining a realistic view of a company’s performance may involve numerous complex adjustments. Mr. Stewart’s list includes the following: "inventory costing and valuation; seasonality; depreciation; revenue recognition; the writing off of bad debts; the capitalization and amortization of R&D; market-building outlays, restructuring charges, acquisition premiums and other ‘strategic’ investments with deferred payoff patterns; mandated investments in safety and environmental compliance; pension and post-retirement medical expense; valuation of contingent liabilities and hedges; transfer payments and overhead allocations; captive finance and insurance companies; joint ventures and startups; and special issues of taxation, inflation and currency translation."

As a result, most firms applying EVA make only a limited number of adjustments (frequently fewer than five), reflecting those most critical for the firm. Yet depending on the circumstances, failure to account for a particular adjustment may significantly distort EVA performance. The adjustments are designed to convert NOPAT, which is based on accounting figures, to the after-tax cash generated by the business. For example, while account-ing rules require companies to expense research and development (R&D) costs even though they may be more appropriately thought of as an investment in future products, a NOPAT adjustment might capitalize R&D expenses and amortize them over four years. Based on the numerous possible adjustments and the difficulty of communicating the new measurement tool throughout the firm, it is sometimes difficult to apply EVA successfully in a healthy firm environment, let alone a firm in distress.

A recent bankruptcy matter illustrates the situation. Immediately prior to the bankruptcy, the firm hired an EVA consultant to improve the performance of the firm. While EVA typically has multiple benefits, it was the wrong medicine for the company’s disease. First, because the company incorporated only a few adjust-ments, its EVA analysis was based primarily on earnings, not cash. A firm in distress must first consider its immediate cash position. Only after the company has resolved any immediate cash hemorrhaging can it focus on creating long-term value for its shareholders. Second, performance measures for a firm in distress are secondary. Such a firm is typically suffering losses and facing eroding market share. Performance for the distressed company involves meeting payroll, not improving ROE. Third, the objectives of shareholders and creditors are likely in conflict when firms are in distress. The focus of performance measures, the creation of long-term value, is directed toward the objectives of shareholders, not the immediate cash needs of creditors.

While traditional performance measures have little relevance for a firm in distress, they do have potential relevance for the firm past the critical period of cash instability and on the road to recovery. In particular, when consulting with a business unit, the turnaround specialist must determine which value proxies are most appropriate.

For the distressed firm, cash can quickly evaporate. The speed at which a cash crisis can develop is a function of its business risk, cyclicality and financial risk, as well as its overall sensitivity to economy-wide fluctuations. The greater a firm’s cash sensitivity, the less relevant are traditional earnings-based accounting measures. Moreover, EVA, without all relevant adjustments, is also an earnings-based measure. The greater the necessary number of adjustments, the less relevant EVA becomes.

To create long-term value, it is necessary to assess cash needs relative to cash availability. For the cash-sensitive business or business unit, a value proxy we call cash value added (CVA) is more appropriate. CVA is a business unit’s operating cash, less the charges for the capital employed by the unit. A business’s cash needs will depend on the firm’s cash sensitivity and its anticipated growth rate.

Exhibit I presents a method for selecting an appropriate value proxy for a business unit on the road to recovery.

Quadrant I reflects a rapidly growing, post-bankruptcy firm in a cash-sensitive business. Traditional EVA would likely be inappropriate for this firm because of EVA’s reliance on earnings, not cash. However, because of Quadrant IV’s low cash sensitivity and expected slow growth, a firm in this quadrant is a business for which EVA might appropriately reflect the unit’s performance. A business unit in either Quadrant II or III will likely find CVA more appropriate. Again, in these quadrants the reliance on cash is a key factor in selecting CVA as an appropriate per-formance measure: Quadrant II because of the high cash sensitivity of the business, and Quadrant III because of the unit’s rapid growth rate.

One of the relevant issues in assessing the success of the implementation of EVA and CVA is the firm’s capability to relate these measures to an incentive com-pensation plan that encourages managers to act as owners. This is particularly important for managers and executives who are charged with turning a company around. Traditional incentive plans relate bonuses to the achievement of a target negotiated with upper management or the board, a process that often corrupts both planning and budgeting by perversely encouraging managers to understate the firm’s true potential, and to underperform as a result. This is particularly hazardous for a firm coming out of a distressed situation because of its limited cushion for error.

EVA and CVA present a far better system of incentives than traditional incentive plans. A properly devised bonus system that rewards improvements in EVA and CVA can transform managers to owners of the units under their control. As a result, they become more entrepreneurial and operate with a greater sense of urgency.

Obviously, different levels of manage-ment require differing compensation mixes, with each manager’s bonus based on the specific level of EVA or CVA that is affected. While senior executives should have bonuses tied to total return, their compensation should also be tied to the firm’s company-wide EVA or CVA. Meanwhile, middle managers and those having responsibility over specific assets or having profit and loss responsibility should have their compensation tied to value created under their control, namely their unit’s EVA or CVA. Thus, a business unit manager with profit and loss, inventory and receivables responsibility will have a direct incentive to minimize the amount charged to the unit for capital employed, and thus be incentivized to avoid having excess inventory. Moreover, since it is the improvement in EVA and CVA, not their level per se, that typically creates value for the firm, it is this improvement which should be tied to management compensation.

For the firm evolving out of financial distress, value creation becomes the ultimate long-run objective of the corporation. However, the search for the ideal value proxy has been going on for decades and will no doubt continue for many more. Net earnings, EPS, ROE, ROA and now EVA and CVA have all been considered as preferred measures of performance. Since each is a surrogate for value creation, the difficulty is in accurately assessing the true value created and in providing appropriate incentives for differing levels of the organization to create value. Value creation is typically associated with healthy, growing firms, yet it may well be even more relevant for the long-run health of the previously distressed firm now on the road to recovery.