By Matthew Smith
As a business owner your primary goal in life is to get your managers to increase shareholder value.
To work out if your managers are in fact either creating or destroying value can be a difficult and daunting task. You are bombarded with many financial ratios from managers and investment analysts which are supposed to aid you in ascertaining how a business will perform.
However, what you may not realise is that many of these so called performance metrics such as; Return on Capital/Equity, Earnings per Share & Profit Margins are not a reliable guide and are very misleading. These ratios do not show you how a company has truly performed, which, in essence comes down to whether or not your highly paid managers have made the correct decisions.
Everyone loves a business with a high return on equity, I don’t know of anyone who doesn’t.
A large business actually paid its managers their bonuses based on the increase in the return on equity. This remuneration policy adopted by the board of directors has caused managers to load up the balance sheet with debt which has increased profits and decreased the equity.
The business in question is in fact a recent fantastic example of the heavy reliance which has been misplaced in the Return on Equity ratio by owners and managers, the business was Lehman Brothers.
The only two ratios that will ensure your highly paid managers are making the correct decisions and are creating shareholder value by not starving the stars and feeding the dogs are Economic Value Added (EVA) & EVA Momentum (EVAM).
EVA is a financial performance measure which calculates the true economic profit of a business. EVA is calculated as net operating profit after income tax minus a charge for the cost of capital employed.
This metric allows you to establish if management's decisions have created shareholder value, merely broken even or destroyed some of your shareholding's value.
EVAM is the next step on from EVA, and is currently the only financial ratio that cannot be fooled with by managers or analysts. EVAM is a percent metric and is calculated as the businesses economic profit (or EVA) divided by its revenue from the prior period.
EVAM in plain English is the size-adjusted change in economic profit and qualifies itself as the missing link in business management as it possesses all of the following qualities;
• Its based on economics not accounting
• Its a measure to maximize
• Size neutral
• Situation neutral
• Acts as a early warning system
• Market calibrated
How come I am writing about this?
I am an investment professional who believes in education and aiding you to be fully informed. I aim to help create greater transparency in the corporate governance arena and I wish to see management's interests become truly aligned with your objective of maximising shareholder value as a business owner.
Grow your investments, give Matthew a call on (07) 4771 4577