Every Manager's Guide to Business Processes:

The concept of EVA is well established in financial. theory, but only recently has the term moved into the mainstream of corporate finance, as more and more firms adopt it as the base for business planning and performance monitoring. There is growing evidence that EVA, not earnings, determines the value of a firm. The chairman of AT&T stated that the firm had found an almost perfect correlation over the past five years between its market value and EVA. Effective use of capital is the key to value; that message applies to business processes, too.

The main differences between EVA, earnings per share, return on assets, and discounted cash flow, the most common calculations, as a measure of performance are as follows: 

• Earnings per share tells nothing about the cost of generating those profits. If the cost of capital (loans, bonds, equity) is, say, 15 percent, then a 14 percent earning is actually a reduction, not a gain, in economic value. Profits also increase taxes, thereby reducing cash flow, so that engineering profits through accounting tricks can drain economic value. As Bennett Stewart, the leading authority on EVA, comments, the real earnings are the equivalent of the money that owners of a well-run mom-and-pop business stash away in the cigar box. Renowned investor Warren Buffett calls these "owner's earnings": real cash flow after all taxes, interest, and other obligations have been paid.
  
  
• Return on assets is a more realistic measure of economic performance, but it ignores the cost of capital. In its most profitable year, for instance, IBM's return on assets was over 11 percent, but its cost of capital was almost 13 percent. Leading firms can obtain capital at low costs, via favorable interest rates and high stock prices, which they can then invest in their operations at decent rates of return on assets. That tempts them to expand without paying attention to the real return, economic value-added.
  
  
• Discounted cash flow is very close to economic value-added, with the discount rate being the cost of capital. 

Determining a firm's cost of capital requires making two calculations, one simple and one complex. The simple one figures the cost of debt, which is the after-tax interest rate on loans and bonds. The more complex one estimates the cost of equity and involves analyzing shareholders' expected return implicit in the price they have paid to buy or hold their shares. Investors have the choice of buying risk-free Treasury bonds or investing in other, riskier securities. They obviously expect a higher return for higher risk. To attract investors, weak firms must offer a premium in the form of a lower stock price than stronger firms can command. This lower price amounts to the equivalent of a higher interest rate on loans and bonds; the investor's premium increases the firm's cost of capital.

Cash flow and the cost of capital employed to generate that flow have become the key determinants of business performance, with earnings per share increasingly a misleading or even damaging target for strategy and investment. When a firm switches from FIFO (first in, first out) to LIFO (last in, first out), its cost of goods assumes the price of the most recent purchases of materials in inventory. This typically reduces its profits because the older purchases cost less than the more recent ones. Yet the firm's stock price will rise, even though its reported profits drop, because it pays less in taxes, thus increasing its after-tax cash flow. The money spent to acquire the goods in inventory is exactly the same regardless of which method is used, but LIFO increases economic value-added.

The key business processes of the firm are capital. That fact is obscured by accounting systems that expense salaries, software development, rent, training, and other ongoing costs that are integral to a process capability and that treat the cost of displacing workers-a frequent by-product of process reengineering, downsizing, and the like-as an "extraordinary item" on the income statement. By treating processes as capital assets or liabilities, firms can and should ensure that they directly contribute to economic value-added. The following quotation summarizes the issues here. For "operations" in the first sentence, we can just as accurately substitute "business processes." 

How much capital is tied up in your operations? Even if you don't know the answer, you know what it consists of: what you paid for real estate, machines, vehicles and the like, plus working capital. But proponents of EVA say there's more. What about the money your company spends on R&D? On employee training? Those are investments meant to pay off for years, but accounting rules say you can't treat them that way; you have to call them expenses, like the amounts you spend on electricity. EVA proponents say forget the accounting rules. For internal purposes, call these things what they are: capital investments. No one can say what their useful life is, so make your best guess-say five years. It's truer than calling them expenses. ("The Real Key to Creating Wealth", Fortune, September 1993.)