Warren Buffett's partner, Charlie Munger, once said, "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. And never a year passes but I get some surprise that pushes my limit a little farther."
When corporate boards use bad incentives for management's pay, disaster often ensues. (Think Lehman Brothers.) Incentives based on singular metrics such as revenue growth, EBITDA, ROE, or earning per share are easily manipulated and gamed. Fortunately, there is a better way: EVA momentum.
Creator Bennett Stewart of EVA Dimensions, who also co-created EVA (Economic Value Added), calls EVA momentum "the only percent metric where more is always better than less. It always increases when managers do things that make economic sense."
So what does this mean for investors? A positive reading on EVA momentum means that a company has created value by increasing its EVA; a negative EVA momentum means that the company's destroying value. EVA momentum is one of the few, if not the only, performance measures with such a clear dividing line between good and bad performance.
The best companies create value in excess of their cost of capital, as reflected by positive EVA momentum. The higher the EVA momentum, the more value management's creating.
Let's look at Boston Scientific and three of its medical equipment-industry peers to see how effectively they create value. Here are the trailing four quarters' worth of EVA momentum figures for each company over the past three years, and rankings by percentile in the medical equipment industry for the past 12 months' EVA momentum.
Source: EVA Dimensions LLC.
Of these four medical equipment companies, Becton Dickinson and Stryker's management have been increasing value creation each year. Meanwhile, both Boston Scientific and Baxter International decreased their EVA compared to 2009, leading to negative EVA momentum scores for 2010. As they made less than their cost of capital, they are destroying shareholder value.
Businesses with high EVA momentum are effectively creating value. It will be interesting to see how useful this extremely new metric proves for companies and investors. If it lives up to its promise, EVA momentum will be an essential tool in investors' arsenals.
Another tool for better investing
Most investors don't keep tabs on their companies' fundamental value. That's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home-run stocks that provide the market's best returns.
We can help you keep tabs on your companies with My Watchlist, our free, personalized stock tracking service.
Dan Dzombak recommends you read The Best Investment Advice You Will Ever Get If You Have Under $100k. He does not own shares in any of the companies mentioned. His musings and articles he finds interesting can be found on his Twitter account: @DanDzombak.
Becton Dickinson and Stryker are Motley Fool Inside Value picks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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