"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.
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 a company has created value by increasing its EVA, and a negative EVA Momentum means EVA and, thus, value have decreased, signaling a destruction of value. EVA Momentum is one of the few performance measurements, if not the only one, with such a clear dividing line between good and bad performance.
The best companies, then, create value in excess of their cost of capital, as reflected by positive EVA momentum. The higher the EVA momentum, the more value management is creating.
Let's look at Activision Blizzard
Source: EVA Dimensions LLC.
Nearly all of these software companies created value this past year, with only Pegasystems destroying shareholder value. Surprisingly, Red Hat was the only one that consistently created value over the past three years, with the remaining three each showing negative EVA momentum in 2009. Investors will certainly hope they can keep up the positive performances moving forward.
Businesses with high EVA momentum are effectively creating value. It will be interesting to see how useful this extremely new metric proves to be for companies and investors. If it lives up to its promise, it 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 that you read The Best Investment Advice You Will Ever Get If You Have Under $100k. He owns no shares in any of the companies mentioned. Find him on Twitter at @DanDzombak to check out his musings and see what articles he finds interesting.
Take-Two is a Motley Fool Rule Breakers choice. Activision Blizzard and Electronic Arts are Motley Fool Stock Advisor recommendations. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. The Fool owns shares of Activision Blizzard and Take-Two. We Fools don't 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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