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Creating Wealth With EVA

By Dale Wettlaufer - Updated Nov 15, 2016 at 5:14PM

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Understanding the concept of Economic Value Added can do great things for your portfolio.

This classic investing article was originally published Dec. 31, 1998. Some information has been updated.

Have you ever read Graham and Dodd's Security Analysis? As an introduction to investing, it's pretty tough. It's dense with information and insights, and one must be at least semi-fluent in accounting and financial vocabulary to really get the most out of it.

As a completely viable alternative for beginning to intermediate investors who are searching for a good framework for looking at the investing world, The Intelligent Investor is Graham's successful attempt at boiling down many of the concepts found in Security Analysis to a more friendly form.

Until now, investors and business owners who want to understand the concept of Economic Value Added have gone straight to G. Bennett Stewart III's The Quest for Value: The EVA Management Guide. One of Amazon.com's readers reviewed the book: "Very Useful, Conceptually Perfect. This book takes you step by step through the direct link between corporate performance and valuation."

"Conceptually "perfect" might be pushing it a bit, but the consulting firm of Stern Stewart & Co. has put together a very tight way of understanding business conceptually and practically. The company's method, which accounts for the interaction of all three financial statements, is a much better way of understanding corporate performance and valuation than simply looking at earnings per share growth. EPS growth in the short term doesn't mean much if you can't quantify the economic resources needed to accomplish that growth.

The problem with Stern Stewart's original approach to the explanation of EVA is that it can be a pretty heavy meal for beginning and intermediate investors. That's is a shame, since beginning investors should be introduced to this subject before they let tangential issues dominate their investment thinking. For instance, margins alone are tangential to the whole. They are not the whole. Beginning investors don't learn early enough about capital management, leverage, and accounting distortions -- why inventory turns, asset turns, financing decisions, and correcting distortions introduced by generally accepted accounting principles all feed into the whole of running businesses and assessing businesses.

Happily, Stern Stewart & Co. vice president Al Ehrbar has written a better introduction to EVA, titled EVA: The Real Key to Creating Wealth. Ehrbar says many of the same things Stewart says in his book; he just says them more clearly and succinctly. Perhaps the most important concept that EVA can introduce to investors, one that isn't found in many valuation methods, is that equity is not free. Many explanations for valuing companies look at the cost of debt, but don't provide a discussion of the cost of equity, which is kind of like learning about arms in anatomy class but never discussing legs.

While Stewart's book on EVA is like advanced financial anatomy, Ehrbar's book is more of an introduction that leads you on to Stewart's more definitive work. It also stands alone quite well, just as The Intelligent Investor stands on its own as well as serving as a prelude to Security Analysis.

In addition to introducing the calculation of EVA and its significance for both investors and managers, EVA: The Real Key to Creating Wealth also contains some excellent case studies on the companies that have used the EVA financial management system. The most famous of these is Coca-Cola (NYSE:KO), whose legendary CEO Roberto Goizueta said in 1995: "We are very pleased to have been one of the first on board the EVA wagon. EVA has given our people a very useful tool for running their individual business units and a sound principle to guide their daily behavior."

Other companies covered in the book that have adopted EVA successfully include SPX (NYSE:SPW), Herman Miller (NASDAQ:MLHR), Equifax (NYSE:EFX), Federal Mogul, and Centura Banks. All help readers see the theory put into practice. If you are looking for a book that explains how EVA works, how it has been applied by real companies, and how an understanding of EVA can help you improve your analysis of companies, Ehrbar's work is the better choice for those closer to the beginner's end of the spectrum.

Coca-Cola is a Motley Fool Inside Value pick. For more great companies trading at deep discounts, take a 30-day free trial of the newsletter. Amazon.com is a Stock Advisor selection.

Fool contributor Dale Wettlaufer is the former TMFRalegh. The Fool has an ironclad disclosure policy.

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