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."
For corporate boards, using bad incentives for management's pay can be disastrous (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.
Created by Bennet Stewart of EVA Dimensions, co-creator of EVA (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."
So what does this mean for investors? The best companies are creating value greater than 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 Wal-Mart and three of its discount-store 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 Year|
Source: Capital IQ and author's calculations.
Of the four discount-store companies, Target's management has been creating the most value, while Wal-Mart places second. Suprisingly, Costco is the only company of the four to actually have negative EVA Momentum, showing that the company has not produced value above its cost of capital.
Businesses with high EVA momentum are effectively creating value. It will be interesting to see how useful this new metric proves to companies and investors. If it lives up to its promise, it will be an essential tool in investors' arsenal.
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: @DanDzombak.
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