Incentive Compensation and EVA
Pay-for-performance schemes try to align managers with owners, but the metric chosen shapes behaviour. Tying bonuses to EPS or accounting earnings rewards reported profit and can be gamed, since earnings ignore the cost of equity. Economic Value Added (EVA), defined as , charges for all capital and so rewards genuine value creation rather than accounting optics. Stock options grant a call on the firm’s own shares, which links pay to the share price but adds convexity that can encourage excess risk. The design problem is to pay for value created, not for earnings that flatter the income statement.
Why it matters
People do what they are paid to do, so the measure in a bonus formula quietly sets the firm’s strategy. Pay on EPS and managers will chase EPS, even through buybacks or projects that lift earnings while earning less than the cost of equity. Pay on EVA and the capital charge does the policing, since a manager only earns a bonus after every supplier of capital has been paid their required return. Options sharpen the link to the share price but introduce a one-sided payoff, rewarding the upside while capping the downside at zero.
Formulas
Worked examples
A manager runs a unit with NOPAT of A$12m, invested capital of A$100m and a WACC of 10 percent. A bonus pool pays on EVA. What does the manager earn the pool on, and how does it differ from an EPS-based scheme?
The capital charge is 10 percent of A$100m, that is A$10m. EVA is A$12m minus A$10m, which is A$2m, so the manager has created A$2m of value and the pool funds from that surplus. An EPS-based scheme would have rewarded the full A$12m of profit, including projects earning, say, 8 percent that lift earnings but sit below the 10 percent cost of capital. EVA only pays once capital is fully served, so it discourages value-destroying growth that still raises reported earnings.
Common mistakes
- ✗EPS-based bonuses align managers with shareholders. EPS ignores the cost of equity, so managers can raise it through value-destroying actions, which weakens rather than ensures alignment.
- ✗EVA and accounting profit reward the same behaviour. EVA subtracts a charge for all capital, so it rewards earning above WACC, while accounting profit can rise even when returns fall short of the capital cost.
- ✗Stock options give managers exactly the shareholders’ payoff. Options have a convex, one-sided payoff that pays on the upside but floors at zero, which can encourage more risk-taking than owners want.
- ✗Any incentive plan automatically solves the agency problem. A badly chosen metric can deepen the conflict, since managers optimise the number they are paid on, whatever its flaws.
Revision bullets
- •Incentive pay aligns managers with owners, but the metric drives behaviour
- •EPS-based pay ignores the cost of equity and can be gamed
- •EVA equals NOPAT minus a WACC charge on invested capital
- •Positive EVA is the same as ROIC above WACC
- •Stock options link pay to the share price but add convexity and risk
- •Reward value created, not earnings that flatter the income statement
Quick check
Economic Value Added (EVA) improves on EPS as a bonus metric mainly because it
A drawback of compensating managers with stock options is that options
Connected topics
Sources
- Stewart (1991)Stewart, G. B. The Quest for Value: A Guide for Senior Managers. HarperCollins, 1991.Original exposition of Economic Value Added as a performance and incentive-compensation metric.
- Titman & Martin, Ch. 7Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.Links why managers care about earnings to compensation design and the use of economic profit.