Journal of Applied Corporate Finance S P R I N G 1 9 9 4 V O L U M E 7 . 1

How EVA™ Can Help Turn Mid-Sized Firms Into Large Companies by Marc Hodak,

Stern Stewart & Co.

98JOURNAL OF APPLIED CORPORATE FINANCE

HOW EVATM CAN HELPTURN MID-SIZED FIRMSINTO LARGE COMPANIES

by Marc Hodak,Stern Stewart & Co.

98CONTINENTAL BANK JOURNAL OF APPLIED CORPORATE FINANCE

invest significant sums to pursue an opportunity.When asked what he thought of the threat posed bythe giant company, the entrepreneur said simply, “Bythe time they even realize our markets exist, we aretoo far ahead for them to catch up.”

This exchange highlights a recurrent theme inbusiness. Many large companies have become in-creasingly aware of the need to become more“entrepreneurial” in serving their markets. Theyhave talked about and, in many cases, taken signifi-cant steps to push decision-making down into lowerlevels of the organization. In short, they are trying torecapture the dynamism that allowed them to growbig in the first place. Despite such efforts, most largecompanies have fallen far short in their attempts totransform their organizations into entrepreneurial,market-driven enterprises.

I commonly hear laments such as that of amanager at one large company once regarded as theindustry leader—now engaged in a desperate strugglefor survival—telling me he had to wait three monthsfor senior management approval for common officesupplies. Is it inevitable that small, nimble challeng-ers of giants grow into large, bureaucratic defendersof slipping market share?

In this article, I will attempt to explain how somany large companies have come to lose theircompetitiveness and what some firms have done toget it back. My suggestions for reforming largecompanies are fundamentally the same as those Ioffer to owners of more narrowly focused, mid-sizedcompanies attempting to achieve the next stage ofdevelopment. Both processes—transforming mid-sized businesses into large companies and reinvigo-rating large companies that have lost the entrepre-neurial spirit—can be facilitated through use of afinancial performance measure called EVATM.

he head of a small company was describ-ing his competitive successes againstseveral other firms. His industry includeda giant known for its willingness to

CONTROLLED vs. ORGANIC GROWTH(or Why Big Companies Fail)

Success and time eventually allow organiza-tions to evolve into intricate human networks thatprocess and conduct flows of information andresources. Most people think of large, successfulcompanies as having grown according to somestrategy or master plan—a view that might be calledthe theory of “controlled growth.” But I would arguethat, no matter how far-sighted and forceful the CEO,the control theory is not borne out by the experienceof companies that have grown beyond the single-market, single-product stage.

The legendary Henry Ford was highly effectiveat producing Model-Ts “in any color as long as it wasblack.” But he lost his effectiveness, and nearly losthis company, when he tried to maintain the samekind of control over a company that had outgrownthe Model-T. At some point, the specialized knowl-edge necessary for running a company with steel-making capacity, vehicle assembly, and distributionbecame far more than a single mind or committeecould possibly deal with effectively. The structure ofthe company had by then become the product ofspecialized managerial knowledge and decision-making that were beyond the ken of corporateheadquarters.

As in the case of Ford, the organizationalstructure of large businesses is much less the reflec-tion of strategic design than of headquarters’ provi-sional efforts to evaluate and act upon the competingdemands for resources by the diverse operatingunits. In practice, it is the initiatives of numerousoperating managers responding locally to their in-centives and within various organizational con-straints that end up driving a corporate process thatI will refer to as “organic growth.”

Top management thus really does not have achoice between controlled growth and organicgrowth. Attempts by senior management to maintain

T

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control of companies that have developed multipleproducts and markets invariably fail. IBM under thesupervision of Tom Watson, Sr., Ford under thewaning control of its founder, and DEC under thelong reign of Ken Olsen—all were companiesfounded and long managed by celebrated entrepre-neurs, and all eventually stalled and faced (or arenow facing) serious threats to their future. Businesshistory is littered with cases of less fortunate com-panies in which the management successors to thefounders failed to decentralize managerial systemsin time to prevent their demise.

AN EARLY MODEL FOR TOP MANAGEMENT

If size seems inevitably to give rise to problems,how does a small entrepreneurial company trans-form itself into a larger, but still effective multi-market competitor? An instructive case study of howthis can be done was provided by Ford’s competitor,Alfred Sloan’s GM.

Upon taking the helm, Sloan quickly under-stood that GM was growing organically—that theproduct and market decisions driving the company’sgrowth were being made by a myriad of divisionalproduct managers. Conceding his own inability todirect the process, Sloan recognized that the primaryrole of top management was not to dictate strategy,but to provide more or less autonomous operatingmanagers with broad guidance and a set of financialincentives and organizational constraints that wouldencourage value-creating behavior. For example,he gave line managers P & L responsibility andallowed them to incur whatever costs they felt werenecessary to achieve their profit plans. Unlike HenryFord, Sloan did not attempt to control the details ofcar features or materials purchases, but left such day-to-day operating decisions to the managers seekingto maximize the profitability of their units.

Sloan’s framework was a giant leap forward insolving the problem of overcoming the separationof ownership and management interests by gettingmanagers to behave more like owners with respectto their business units.

THE QUEST FOR CAPITAL EFFICIENCY

Profit centers provide accountability for profits.This kind of accountability allows for substantialdecentralization of decision-making with regard tomarketing and operations, which in turn leads to

greater operating efficiency, i.e., the most revenuesfor the least operating cost. It does not allow,however, for decentralization of capital allocationdecisions—and decentralizing capital allocation is aprerequisite to greater capital efficiency, i.e., themost profit for the least investment.

Business units evaluated mainly on operatingprofits are not really concerned with the level ofinvestment required to achieve their profits. Theprimary incentive of operating managers is to growprofits, which they generally do by two means:(1) improving the efficiency of existing operationsand (2) winning more capital appropriations fromheadquarters. Because most corporate measure-ment systems do not hold business unit managersaccountable for new capital investment, they quicklycome to recognize that additional operating profitscan be “bought” with capital expenditures.

This reality, to be sure, has not escaped thenotice of corporate headquarters. And since topmanagement is held accountable for returns oncapital, it has traditionally been reluctant to entrustcapital spending decisions to operating managers,particularly where capital project returns are diffi-cult to measure once the capital has been spent.

Some companies, including GM, have attemptedto promote capital efficiency through the use ofreturn on investment (ROI), return on assets, orother similar return ratio measures. Although usefulmeasures of capital efficiency for evaluating prospec-tive investments in individual projects, return ratioshave not proved effective as after-the-fact measuresof capital efficiency. For one thing, few companiesconduct regular post-investment audits to evaluatethe effectiveness of their new capital spendingprograms. This has made it easy to disguise over-investment in operations (known as “gold-plating”)or to disguise operating costs as investment. Second,return ratios do not lend themselves to comparisonsbetween projects or business units of different scaleor across time. Business units in some cases mayactually have to shrink their ROIs to add value forshareholders.

For comparative purposes, return ratios fail intwo regards. First, they do not provide a benchmarkof the profit or return an enterprise must earn tocover its cost of capital—that is, the minimum returnshareholders would get from an alternative invest-ment of comparable risk. A business must earn asufficiently high rate of return on its total capital (ornet assets) to encourage shareholders to continue

100JOURNAL OF APPLIED CORPORATE FINANCE

committing capital to the firm. The return simplymay not be high enough. Second, return ratios arenot scaled according to the level of capital invested.Managers targeting high returns may forgo largeprojects whose returns exceed their cost of capitalbecause a smaller project (with a very small invest-ment in the ratio’s denominator) has a higher returnratio. In other words, the targeted return is too high.

In Sloan’s day, a little bit of capital efficiencywent a long way. In today’s markets, investors liter-ally have a world of options. Capital is more de-manding now of all returns that exceed the cost ofcapital. Capital efficiency has become a necessaryelement of competition.

Managements of large, multi-product compa-nies can react to the need for greater capitalefficiency in one of two ways. They can maintainrigidly centralized control of capital allocation, orthey can recognize the organic nature of theircompany’s growth and decentralize capital alloca-tion. As it turns out, however, both approaches havemet with generally poor results.

PROBLEMS WITH CENTRALIZATION

Companies choosing continued centralizationtend to meet with predictable problems caused bythe deficiency of knowledge at the center. Theproblem is basically as follows: Business unit man-agers are closer to their markets than corporate staffpeople, and so they are the only meaningful sourceof investment ideas and strategies. In a centralizedstructure, however, the role of operating managersis confined largely to developing project proposalsand projecting returns on those investments. Thereis typically little accountability built into the system,as well as little financial incentive for operatingheads to choose only projects that promise to earnmore than the cost of capital. They may be satisfiedwith returns that are too low. Although the corporatecenter retains final decision-making authority overall proposed projects, it is at a considerable disad-vantage in assessing the reliability of the returnsbeing projected by the business units.

With this combination of greater informationbut little accountability, business unit managers haveincentives to project upwardly biased returns. Thisincreases their chances of getting funding for theirown projects, which in turn increases their prospectsfor promotion, at least in conventionally growth-oriented companies.

Over time, however, and after repeated disap-pointments with the process, the corporate centercatches on to the game and becomes skeptical aboutwhatever returns are being projected. Moreover, tocompensate for their lack of information, headquar-ters begins to demand explanations for the slightestvariances from short-term operating budgets andbegins to apply other controls on the process.Harold Geneen became a business celebrity whileinstalling this “management by numbers” model ofmanagement at ITT. Its limitations, both at ITT andmany other diversified U.S. firms, have revealedthemselves quite clearly.

The end result of this information “game”between headquarters and operating managementis the proliferation of large, bureaucratized organi-zations that I described earlier. At the extreme, onesees billion-dollar companies in which managers aresubjected to the need for headquarters’ approval fora $5000 investment in computers.

At the heart of this problem with large compa-nies, then, is the tension between the business units’superior knowledge of their business prospects andthe corporate center’s control over the allocation ofcapital. Headquarters does not have the informa-tion, and line managers are not typically given theproper incentives, to distinguish reliably betweenpromising and unpromising investment proposals.The consequence is a capital budgeting mechanismthat allows too many low-return projects to goforward while too many good ones go unfunded.

PROBLEMS WITH DECENTRALIZATION

Unfortunately, many companies choosing thepath of decentralization have fared no better. Part ofthis problem stems from excessive corporate diver-sification. The success of companies like GeneralElectric notwithstanding, there are simply limits tothe number of different kinds of businesses that canbe run effectively under one corporate umbrella.General Mills realized this, leading to its spin-off ofits toy and apparel businesses. Also, Eastman Kodak,after spinning off Eastman Chemical in 1993, re-cently declared its intention of divesting SterlingDrug and refocusing on its core photography andimaging businesses.

Once having gotten the right configuration ofbusinesses, there is another challenge that stillconfronts any corporation with multiple markets ordivisions. Management must understand sharehold-

VOLUME 7 NUMBER 1 SPRING 1994101

At the heart of the problem is the tension between the business units’ superiorknowledge of their business prospects and the corporate center’s control over the

allocation of capital. Headquarters does not have the information, and line managersare not typically given the proper incentives, to distinguish reliably between

promising and unpromising investment proposals.

ers’ expectations, at both corporate and businessunit levels, and align their financial performancemeasures with those expectations.

The issue of alignment is as much a problem offinancial history as of company diversity and scale.In the 1960s and much of the ’70s, many U.S.corporations thought they were serving their share-holders just by producing steady increases in earn-ings and EPS. Starting in the mid-70s, however, theshare prices of many diversified growth companiesbegan to lag the broad market, reflecting their failureto earn adequate returns on their additional capitalinvestment (including, notably, their diversifyingacquisitions). This widespread failure, as has nowbecome clear, created many of the restructuringopportunities of the 1980s.

In response to the heightened shareholderpressures of the ’80s for greater capital efficiency,many U.S. companies introduced return-on-invest-ment (ROI) and cash flow measures as substitutesfor accounting earnings. And both of these strategiesworked—but, in many cases, they worked too well.They actually created a strong bias toward“disinvestment.”

Companies or business units with successfulrecords of achieving high returns, especially grow-ing and mid-sized companies, were afraid to dilutetheir current 30 or 40 percent returns on investmentwith projects that promised “only” 20 or 25 percentROIs. Coca-Cola resisted investment in product lineextensions for fear of generating lower returns thanthey were getting from their basic soft-drink busi-ness. IBM lost crucial time getting into PCs becausethe projected returns in that business, although wellabove the cost of capital, were less than what theycould expect from their mainframe business. Thesecompanies targeted returns that were too high andtheir investment opportunities appeared to dry upprematurely.

More seriously deterred, however, were com-panies focusing on cash flow. Because cash flowmeasures are typically arrived at by subtracting allexpenditures from net operating profits, investmenthas an immediate and dramatic negative impact onperformance measures (and, to the extent the twoare linked, bonuses). Operating managers measuredon current cash flow are highly tempted to deferinvestment in promising or even current capabilities,no matter what the return—a problem we have seenrepeatedly at large, sophisticated clients with signifi-cant capital needs.

THREE MODELS OF SUCCESS

How have some companies navigated pastthese difficulties in growing their value? There havebeen three models of success. All three have had theeffect of increasing accountability for managerialuse of capital within the business unit.

Corporate Spin-Offs

First, large companies have spun off divisionsdirectly to their shareholders. Since they are noweffectively running independent firms that dealdirectly with their own lenders and shareholders,the managers of spun-off divisions become di-rectly accountable for the capital tied up in theirbusinesses. Also, many managers of spun-off com-panies own significant stock in the spin-off, fur-ther raising their consciousness of capital use. Spun-off companies are also typically small or focusedenough that a significant degree of central controlcan still be exercised effectively. Examples of suchspin-offs include those of Fisher Price Toys byQuaker Oats and Eastman Chemical by EastmanKodak.

Leveraged Buyouts

A second popular approach during the 1980swas the leveraged buy-out. LBOs promoted a highdegree of capital efficiency because the managerswere directly responsible for providing an explicitrequired return on capital in the form of interest(and principal) payments on the company’s debt.By effectively making the cost of capital highlyvisible and compelling (default in the case of amanagement buyout could mean loss of the manag-ers’ investment as well as their jobs), provided verystrong incentives for improved performance. Aca-demic evidence on LBOs to date suggests that theaverage transaction has led to a doubling of thecompanies’ pre-interest operating cash flow as soonas two years after going private.

As in the case of spin-offs, LBOs were typicallysmall or focused enough (often serving a singlemarket) that substantial control could still be exer-cised usefully by top management. One good ex-ample was the LBO of the battery-maker Duracell,which, based on its post-LBO public offering, hadachieved far higher profitability than as an alreadyprofitable division of Kraft.

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Reforming Companies from Within:The Case for EVATM

A third approach was to find internal measuresof business unit performance to promote capitalefficiency without interfering with profitable growth(or breaking up or leveraging companies). Manycompanies introduced combinations of operatingprofit, cash flow, and ROI in their internal measure-ment systems. This multiple focus helped somewhatin making managers more aware of the need tohusband capital resources wisely in the growth oftheir businesses. However, it is difficult to serve morethan one master. Multiple measures add complexityand require business managers to attain an unreal-istically high degree of financial understanding.

A better internal measure has proved to beEconomic Value Added, or EVATM. EVATM is simplyoperating profit less a charge for the use of capital.It capitalizes rather than expenses corporate invest-ment (including some kinds of investment, likeR & D, that accountants typically expense), andthus looks much like the earnings measures thatbusiness unit managers are already accustomed todealing with. At the same time, it has a conceptualtie to shareholder value: In accordance with modernfinance theory, it encourages managers to undertakeall projects that promise to earn their cost of capital,and to reject all others.

Companies such as AT&T, Coca-Cola, andQuaker Oats have used EVATM (or some equivalentmeasure) as the basis for imposing the discipline ofcapital efficiency from within the organization. Thetop managements of EVATM companies are able to lettheir business units grow organically without thesense, as one CEO expressed it, “that I am the onlyone who cares about the shareholders.”

CONCLUSION

Companies contemplating the transition fromsmall to large are generally doing something right.They have managed their resources, at least up to thispoint, in a way that has allowed them to capitalizeon market opportunities.

For most companies at this stage, however, thegrowth has been driven by success of a fairly narrowrange of products, often in well-defined markets.Sustaining this type of growth is not simply a matterof doing more of the same. The transition to becom-ing a larger company inevitably creates far greaterknowledge requirements than can be handled by asingle management group at headquarters.

It is in large part the failure of mid-sized, single-product companies to establish incentives and con-straints that promote capital efficiency that interfereswith their efforts to become large companies. At thesame time, the intensifying global competition forcapital is threatening large companies that were oncesuccessful.

EVATM is an internal measure of profitabilitythat has a built-in measure of capital efficiency—one that can be used both by small companies thatwant to grow and by large firms that want torecover the dynamism of their past. Rewardingdivisional or operating heads according to EVATM

can help prevent the corporate sclerosis we havebeen led to associate with the growth of U.S.companies into multiple markets. It can preservethe entrepreneurial outlook of business unit man-agement and create the right motivations within theorganization. By so doing, the company will havereceived the managerial benefits of spinning offunits or undergoing LBOs without their attendantcosts or financial risks.

MARC HODAK

is a Vice President of Stern Stewart & Co., the publisher of thisjournal. He has an MBA from the University of Pennsylvania’s

Wharton School, and worked for six years at Conrail Corpora-tion, four of them as a business manager.

EVATM is a trademark of Stern Stewart & Co.

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