ISS Discusses the Role of “Economic Value Added” in Pay-for-Performance Analysis

Performance-based long-term executive compensation is generally determined by a company’s achievements over three-year measurement periods. Total Shareholder Return (TSR), however, doesn’t always accurately reflect the performance of a company or management team during that period. Macroeconomic factors, tax policy, financial leverage, investor sentiment, the stage of the business cycle, and more can influence and in some ways distort the meaning of TSR measurements.

Investors recognize shortcomings with relying on TSR alone to judge CEO pay. They tell us they are looking for other sources of information to give them a better, more complete sense of how well a company is performing. When responding to ISS’ 2016-2017 annual policy survey, 79 percent of investors – and 68 percent of non-investors – supported incorporating performance measures in addition to TSR in ISS’ quantitative pay-for-performance methodology.

GAAP-based measures do not always accurately portray true economic performance

In response, starting two years ago, ISS instituted Financial Performance Assessment, or FPA. The assessment employs three or four GAAP-based metrics for each company—selected from ROIC (return on invested capital), ROE (return on equity), ROA (return on assets), Operating Cash Flow Growth, and EBITDA Growth, all rated against peers—to provide a secondary perspective on company performance. The assessment has proven useful, but ISS also sees significant issues with it – notably, the metrics are inherently influenced by accounting statement standards that can at times distort true economic performance. To that end, ISS will begin to provide additional information to investors – over and above the TSR and GAAP-based metrics – to assist them in evaluating pay and performance alignment.

EVA represents a valuable additional assessment of company performance

ISS believes that Economic Value Added (EVA) concepts may offer a valuable tool to supplement TSR and help investors better assess pay and performance alignment. EVA represents the economic profit a company earns after meeting all its obligations – including the demands of capital providers.

A company with positive EVA is performing well. It is generating a return on capital high enough to more than meet its cost of capital. And if EVA is negative, a company is falling short of this competitive hurdle (i.e. it is earning below its cost of capital), and it may do so while its book income and cash profits are strongly positive and rapidly growing. EVA thus introduces a more demanding and at the same time more reliable means of assessing the profit performance of a company. Once EVA is computed, ISS uses a variety of size-adjusted EVA-based ratio metrics that enable comparisons with peers.

EVA complements TSR in pay-for-performance evaluations. Unlike TSR, which is a market measure that depends on investor expectations and is amplified by financial leverage, EVA reflects actual results, cuts through differences in capital structures and business models, and can be traced to a firm’s business fundamentals and financial statements.

ISS will present EVA metrics for informational purposes in the 2019 Proxy Season

TSR and the existing GAAP-based FPA metrics will remain determinative in pay-for-performance assessments during the 2019 ISS policy year. However, ISS will compute, report and analyze a set of EVA metrics, and include them in this year’s proxy reports.  ISS will pay close attention to, and attempt to learn from, situations where the EVA metrics notably diverge from TSR and the four conventional GAAP metrics used in FPA. ISS will also seek input from institutional investors regarding the value they see in the EVA metrics.

ISS remains neutral on executive compensation performance measures

ISS has consistently taken the position that the adoption of TSR as a measure to test pay alignment should not be construed as a preference or recommendation for using TSR to determine executive pay; in fact, in 2012, when first describing the quantitative pay-for-performance assessment methodology, ISS noted that it “does not advocate that companies use TSR as a metric underlying their incentive programs; on the contrary, shareholders may prefer that incentive awards be tied to the company’s short- and long-term business goals.” That holds true today as it did then; ISS still does not take a position on whether any one metric or set of metrics – including TSR and EVA – should be used in a company’s executive compensation program.

Introduction to EVA: Measuring Economic Performance

At its essence, EVA is a simple three-line calculation – it is sales, less all operating costs, including taxes and depreciation, less a full weighted-average cost-of-capital charge on all the capital, or net assets, used in business operations:

Sales less operating costs can be defined as NOPAT, or Net Operating Profit After Tax; the capital charge, moreover, is computed by multiplying the firm’s capital base by its cost of capital. Thus, EVA can also be stated as:

EVA recognizes investors’ needs by deducting a required return on capital before it counts profit. To increase EVA, managers must increase profits above the opportunity cost of funding any new capital investments. EVA naturally holds managers accountable as stewards of investor money.

NOPAT and Capital also incorporate the standard set of adjustments. For example, they exclude excess cash and the related investment income, and reflect writing off R&D over time instead of expensing it. EVA is thus a better indication of how well a company’s business is performing from a strategic perspective.

EVA starts with GAAP financials and makes rules-based adjustments

Company managers often reject reported financial metrics in favor of “Non-GAAP” metrics that they feel better portray their firm’s true performance. However, the adjustments to arrive at the Non-GAAP metrics are not standardized; they typically vary even among companies in the same industry, and frequently vary from period to period. And, in a compensation context, the non-GAAP adjustments that companies make for calculating goal achievement are sometimes different from the adjustments explained in the financial statement reconciliation.

EVA mitigates these issues by consistently applying a standard set of rules to adjust the reported results for all companies. As a result, EVA produces a profit performance measure that is generally more tightly linked to value and more comparable across companies and over time than can be obtained from reported results or ad hoc measures.

The table below displays a few of the adjustment rules.


Sample of Accounting-to-EVA Adjustment Rules
Adjustment Technique Impact
Capitalize Investments in Intangible Assets Instead of deducting R&D and Advertising from profit, add it to Capital, subject to a capital charge, and amortize the spending over 5 years for R&D and 3 years for Advertising. EVA is smoothed and more comparable; it motivates managers to step up spending on promising opportunities, and to resist cuts just to make near term earnings.
Capitalize Unusual and Non-Recurring Charges (Less Gains) Do not deduct the one-time charges from profits; rather, add them to Capital, subject to an on-going capital charge. Impairments are inconsequential; there is an impetus to restructure promptly and efficiently, sell assets worth more to others, manage risks and minimize non-recurring charges.
Eliminate Excess Cash Remove excess cash from Capital and the associated investment income from NOPAT. EVA measures business performance; it is unaffected by retaining or paying out excess cash, because shareholders own the cash whether it is in the firm or in their hands.
Smooth Taxes Compute tax at an assumed standard tax rate; credit EVA with the cost of capital saved on the net balance of deferred tax. Eliminates noise in the tax calculation; recognizes the value of paying taxes later.

This post comes to us from Institutional Shareholder Services. It is based on the firm’s report, “Using EVA in Pay-for-Performance Analysis,” available here.