Incentive pay measures of economic profit (EP) or economic value added (EVA) are often touted as the answer to executives growing the business without considering the costs. However, these measures can also foster underinvestment.
The application of these measures for executive incentives received more attention this year, after proxy advisor ISS announced that economic value added will feature in its research reports. (This followed ISS’ acquisition of EVA Dimensions in 2018, see HERE) .
But companies should be cautious.
Economic Profit’s initial period expense problem
Economic profit has an unintended consequence.
It tells us the return the company is generating on capital that has already been invested, and these investments were sometimes made many years ago.
Economic profit is typically calculated based on net operating profit after tax less a capital charge based on the carrying value of operating assets of the company.
Economic profit is affected when companies recognise the non-cash cost of depreciation on plant and equipment as a charge to earnings: over time the accumulated depreciation is subtracted from the carrying value of the asset.
Often, new investments cause economic profit to decline because executives will initially be charged both for depreciation plus a capital charge recognising the cost of acquiring the asset. As time passes, economic profit often automatically rises as assets depreciate away and the capital charge declines.
This focus on accounting value of assets rather than the replacement value therefore means older assets contribute to a higher return, while new investments might reduce it.
Given the typical LTI performance period is only 3 years, executives may be encouraged to underinvest or seek out depreciated assets in order to minimize the initial period expense and meet LTI targets.
Fixing incentive measures so CEO’s do not underinvest
Boards can diversify this risk by having the LTI vest partly based on achieving capital efficiency targets and partly based on growth targets, but striking the right balance can be challenging.
Another method to calculate economic profit, which avoids the issue of asset depreciation weighing on short term targets, is to use a cash-based alternative economic profit measure. This measure, also known as Residual Cash Earnings is obtained by:
- Defining earnings as EBITDA less tax (by adding back depreciation to income); and
- Defining the capital of the company to include gross un-depreciated property, plant and equipment (by adding back the accumulated depreciation to arrive at the historic cost for depreciating assets), plus net working capital and other net operating assets.
This removes the effect of depreciation and the initial period expense problem, putting the performance of new and old assets on an equal footing and therefore reducing the disincentive for executives to make new investments.
Any issues in implementation?
This method would not be a measurement issue for most larger company boards and CEOs. Periodic results reporting could be adjusted easily enough.
However, public companies may find they have to spell out the arithmetic for investors and proxy advisers, and reconcile these with statutory accounts.
While Residual Cash Earnings may appear less straightforward than traditional measures of economic profit, and at first glance may seem to ignore that depreciation is a very real expense for capital-intensive companies, it can be presented transparently for shareholders as it is based on financial statements.
It can provide boards with a more valid capital efficiency measure.
It does not penalise executives in the short term for investing in the long-term growth prospects of the business.
Worth thinking about.© Guerdon Associates 2022 Back to all articles