For What It's Worth

The first step in applying EVA to your business is to adjust your accounting measures. Stern Stewart has identified 160 different potential adjustments to common accounting methods to do this. Most companies generally use between five and 15. Two of the most important are ending the amortization of goodwill and changing research and development outlays from an expense item to a capital investment. Other adjustments are made according to your industry and your company.

After you modify your accounting methods, you take the figure for the net operating profit after taxes and subtract an estimated cost of capital from it. The net operating profit after taxes is basically the bottom line, with financing expenses such as interest and principal payments on loans added back in. The cost of capital varies according to economic conditions and the risk of the underlying business, but it's generally 8 to 14 percent.

The resulting number shows how much--if any--value your company is adding through its operations. This information can help you make decisions that will build your company's value rather than deplete it.

There are three ways business owners can build value, according to Stern Stewart. The first is to increase returns on invested capital. You may, for instance, find ways to boost profit margins or increase sales without adding more capital. The second way is to invest more capital--as long as it's done so that returns exceed capital costs. For example, you might invest in new equipment, marketing campaigns or additional employees. The third way is to reduce the capital you invest by selling assets, shrinking inventory or reducing accounts receivable. Weatherhead's managers found ways to boost value by cutting costs, increasing sales and increasing throughput (raising production volume without increasing investment).

Weatherhead says that while EVA may look like a cost-reduction tool, it's just as much about boosting sales. "It tells you very clearly to look at the top line," he says. "You have to search out ways to get double-digit growth because that helps you cover the cost of your capital."

This article was originally published in the December 1998 print edition of Entrepreneur with the headline: For What It's Worth.