Warren Buffett's partner, Charlie Munger, once said, "I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther."
When corporate boards use bad incentives for management's pay, disaster often ensues. (Think Lehman Brothers.) Incentives based on singular metrics such as revenue growth, EBITDA, ROE, or earning per share are easily manipulated and gamed. Fortunately, there is a better way: EVA momentum.
Creator Bennett Stewart of EVA Dimensions, who also co-created EVA (economic value added), calls EVA momentum "the only percent metric where more is always better than less. It always increases when managers do things that make economic sense."
So what does this mean for investors? A positive EVA momentum reading means a company has created more value by increasing its EVA while a negative EVA momentum reading means EVA has decreased, signaling less value creation. EVA momentum is one of the few, if not the only, performance measures with such a clear dividing line between good and bad performance.
The best companies, then, create value in excess of their cost of capital, as reflected by positive EVA momentum. The higher the EVA momentum, the faster management is creating value.
Let's look at Green Plains Renewable Energy (NAS: GPRE) and three of its peers to see how effectively they create value. Here are the trailing four quarters' worth of EVA momentum figures for each company over the past three years, and rankings by percentile versus the Russell 3000 for the past 12 months' EVA momentum.
2009 Q2 TFQ
2010 Q2 TFQ
2011 Q2 TFQ
Russell 3000 Percentile
Green Plains Renewable Energy
BP (NYS: BP)
Sasol (NYS: SSL)
Rentech (NYS: RTK)
Source: EVA Dimensions. TFQ = trailing four quarters. NA = not available.
With an EVA momentum of -0.4%, Green Plains Renewable Energy's economic value added decreased year over year, placing it in the 31st percentile of all companies in the Russell 3000. By contrast, all of the three other companies had positive EVA momentum over the past 12 months.
Businesses with high EVA momentum are effectively creating value. It will be interesting to see how useful this extremely new metric proves for companies and investors. If it lives up to its promise, EVA momentum will be an essential tool in investors' arsenals.
Another tool for better investing
Most investors don't keep tabs on their companies' fundamental value. That's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home run stocks that provide the market's best returns.
We can help you keep tabs on your companies with My Watchlist, our free, personalized stock tracking service.
Add Green Plains Renewable Energy to My Watchlist.
Add BP to My Watchlist.
Add Sasol to My Watchlist.
Add Rentech to My Watchlist.
At the time thisarticle was published Dan Dzombak's musings and articles he finds interesting can be found on his Twitter account:@DanDzombak.Sasol is aMotley Fool Income Investorselection. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.