Emerging from the 2019 proxy season, signs suggest that the nation’s largest proxy firm is edging toward adopting a new solution to the thorny issue of pay for performance metrics. ISS introduced economic value added (EVA) as an informational performance measure in its 2019 research reports, but the real indication of its intentions for the metric came with the release of its Annual Policy Survey in July, explains Joe Sorrentino, a principal at FW Cook.
“Based on what we’re hearing and on the survey ISS distributed in July, which typically signals potential policy changes, it seems that ISS is setting the stage for incorporating EVA as a primary financial performance metric,” he says. “2019 was a transitional year, in which they included EVA data in their reports but didn’t use it as a basis for their Say on Pay recommendations. In 2020, that may start to change.”
That prospect reflects an ongoing search among investors for better methods of linking pay with performance. Companies and proxy firms have been largely relying on total shareholder return (TSR) and operational metrics such as revenue, profit and/or financial returns to measure absolute and relative market and financial performance. These metrics are then used to screen for a disconnect between pay and performance that might warrant a challenge. However, ISS has questioned the potential for these measures to be influenced by macroeconomic factors or GAAP accounting practices that could obscure the underlying economic results. “They’re arguing, basically, that other metrics aren’t a true assessment of value creation,” says Sorrentino, who says the proxy firm seems likely to begin supplementing those measurements with EVA-based metrics that focus on measuring a company’s performance based on how much value it creates for shareholders.
All about EVA
In 2018, ISS purchased EVA Dimensions, a firm that measures and values corporate performance based on the EVA framework. EVA attempts to address these limitations by looking at the rate of return a company is earning on its shareholder’s cost of capital. For most companies, EVA is calculated as net operating profit after taxes (NOPAT) less a full weighted average cost of capital (WACC) charge on total capital.
By combining NOPAT and a capital charge (income statement and balance sheet), EVA seeks to effectively measure three key drivers of value creation:
• Operating Efficiency—increasing NOPAT without increasing capital.
• Asset Management—reducing capital tied up in assets and activities that earn less than the cost of capital.
• Profitable Growth—investing capital in positive net present value projects and strategies.
Earlier this year, ISS identified four EVA-based metrics (see table, p. 11) as strong indicators of operating efficiency, asset management and profitable growth. These calculations transform EVA from an absolute dollar amount to ratios and PROXY SEASON 2020 THE ABCs OF EVA THE AGENDA growth rates in an effort to more accurately measure long-term performance and make meaningful relative comparisons, according to ISS. The proxy firm described the metrics in a white paper released in February 2019 as follows: “EVA Margin and EVA Spread, scaled to sales and capital, indicate the magnitude of value creation per unit of sales or capital, while EVA Momentum, which measures the change in EVA over time and scaled to prior sales and capital, gives us a way to index and quantify EVA growth or deterioration over time, and through various market cycles and relative to peers.”