Why is Vodafone in such deep trouble, with a divided board, a disastrous share price and a crumbling strategy? This was supposed to be one European company that was beating the Americans to world domination in a key high-tech industry, mobile phones - sweeping ahead of all others by no-holds-barred acquisitions.
There’s the answer, of course. Vodafone may or may not have assimilated its buys effectively, but that’s not the point. It fell foul of three little letters that express a deep truth: EVA, or Economic Value Added. The concept is a simple fact. Any company has to make profits that exceed its ‘cost of capital’.
That doesn’t just mean debt. Economic Value Added advocates argue that the cost of equity is much higher than that of debt. The equity money entrusted to your care by shareholders could have been invested elsewhere, and will be if your returns become less attractive. Lumping both types of capital together, shareholders expect to better long-term government bonds by several percentage points.
The weighted average cost of equity and debt is the true cost of capital. If that number exceeds profitability, the company is eating its own flesh. But insisting on clearing the capital cost has other virtues. Basing strategy on the cost of equity will do more than impose realism on financing capital projects - including takeovers. It will force managers to concentrate on keeping down capital employed by managing inventories and costs intelligently.
Note that the key financial statistic isn’t the gross margin on sales, but what it helps to achieve: the margin between the cost of capital and its return. Second, managers who aren’t held responsible for their use of capital won’t use it to the best advantage of the business. The two fundamentals apply to any company - the reasons for large-scale corporate downfalls in Europe, including Vodafone, certainly include the damaging propensities identified by the Economic Value Added measure.
But there’s more to the Economic Value Added figuring: what’s the capital? Under Economic Value Added, capital includes not only fixed assets and plant and equipment, but also ‘revenue investment’: that is, expenditure on essentials like R&D, training and even marketing. If Economic Value Added is negative - that is, after-tax operating profits don’t cover the cost of capital - the business is ultimately doomed, even if a company is still showing profits at the operational level. When capital is being savagely eroded, small wonder that investors prefer to put their money somewhere else. Small wonder, either, that high Economic Value Added and high stock market performance show a close correlation, and vice versa: low correlates with low.
Operationally, the concept enforces a close look at the organisation to ensure that capital is properly allocated to those who use the money. That sweeps away the confusion which in many businesses makes proper measurement and direction impossible. Make an individual unit work out its own Economic Value Added by deducting cost of capital from after-tax operating profit. If the result is negative, the call to action is immediate and compelling. At the strategic level,the response may be negative too: close or sell the offending operation or, more important, don’t buy it.
I’ve no hesitation in urging extreme attention to the Economic Value Added performance - not because it’s a management panacea (there is no such thing), but because it represents a test that can’t be fudged and which management must pass. The calculation would certainly have stopped Vodafone’s contested takeover of Mannesmann in its tracks. As it is, that gross Economic Value Added error will haunt the company for years to come.
