"I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it," Warren Buffett's business partner, Charlie Munger, once said. "And never a year passes but I get some surprise that pushes my limit a little farther."
For corporate boards, using bad incentives for management pay can be disastrous. (Think Lehman Brothers.) Incentives based on singular metrics such as revenue growth, EBITDA, return on equity, or earnings per share are easily manipulated and gamed. Fortunately, EVA Momentum provides a better alternative.
Created by Bennett Stewart of EVA Dimensions, co-creator of EVA (which stands for Economic Value Added), Stewart says EVA Momentum is "the only percent metric where more is always better than less. It always increases when managers do things that make economic sense."
For explanations of either term, check out the Fool wiki for EVA and EVA Momentum.
So what does this mean for investors? It means that the best companies are those creating value above their cost of capital, as reflected by a positive EVA momentum. The higher the EVA momentum, the stronger management's value creation.
Let's look at Altria and two of its tobacco-industry peers to see how effectively they create value. Here are the EVA momentum figures for each company over several time periods.
| Related Companies | 2007 | 2008 | 2009 | 3 Years |
|---|---|---|---|---|
| Altria (NYSE: MO) | 13.6% | 16.0% | (3.3%) | 12.6% |
| Reynolds American (NYSE: RAI) | 2.5% | 1.9% | 2.1% | 4.2% |
| Lorillard (NYSE: LO) | 4.1% | 1.7% | 2.6% | 4.8% |
Sources: Capital IQ, a division of Standard & Poor's; and author's calculations.
The tobacco industry is one of the few I've seen that's consistently able to increase its economic profits, consistently creating value above the cost of capital. Of the three, Altria's management has been creating the most value by a wide margin, while both Lorillard and Reynolds fall relatively near each other at second and third in creating the most value.
Businesses with high EVA momentum are effectively creating value. It will be interesting to see how useful this new metric proves to be for companies and investors. If it lives up to its promise, it will be an essential tool in investors' tool belts.
If you're interested in reading more about any of these stocks, add them to My Watchlist to find all of our Foolish analysis on them.
