The best managers can do for shareholders is to realise returns that exceed the opportunity cost of the capital entrusted to them. That is to generate returns that exceed the returns their shareholders could realistically expect from alternative, equivalently risky investments.

This difference between the returns a firm is able to earn on its projects and the charge it needs to make for that capital is widely known as economic value added (EVA).

But more than intellectual property or valuable brands that keep out competition and preserve pricing power, a truly valuable firm will have a long runway of opportunities to invest more in investments that beat the cost of capital.

It is the margin between the internal rate of return and the required risk-adjusted return, multiplied by the volume of investment undertaken, that makes for EVA and potentially more wealthy owners not margin alone.

The task for managers is to maximise neither margin nor scale but their combination, EVA. For investments in rand today in SA, an averagely risky project, given long-term SA interest rates of about 9% a year, would have to promise a return of more than 14%, on average, to hope to be EVA accretive.

The leading US adviser on corporate governance now agrees with the importance of EVA when evaluating managers. Fortune Magazine of March 29 reports: “On Wednesday, ISS ... announced that it’s starting to measure corporate pay-for-performance
plans using a metric that prevents CEOs from gaming the system by gunning short-term profits, piling on debt or bloating up via pricey acquisitions to swell their long-term comp.

"ISS’s stance is a potential game-changer: no tool is better suited to holding management accountable for what really drives outsized returns to investors, generating hordes of new cash from dollops of fresh capital.”

ISS announced that it’s starting to measure corporate pay-for-performance plans using a metric that prevents CEOs from gaming the system by gunning short-term profits, piling on debt or bloating up via pricey acquisitions to swell their long-term comp.

Positive EVAs or EVA improvement do not translate automatically into returns that beat the share market. The market will always search for companies capable of realising EVA and reward their managers in ways that align their interests with those of their shareholders. Such remuneration practice gives investors useful clues about prospective EVA. It will help them follow the money. Managers will, after all, do what they are incentivised to do.

With a positive EVA, realising as much of it as possible calls for raising rather than paying cash out negative, not positive cash flow after spending to sustain the established capital stock. Not only retaining cash not paying dividends but raising fresh capital, equity or debt can make every sense if EVA is enhanced.

Paying up for prospective EVA will raise share prices and reduce realised market returns. And investment activity that is expected to waste capital will reduce share prices to improve prospective returns. Investors may change their minds about how sustainable EVA will be.

By adding or reducing the time before margins inevitably fade away in the face of predictable competition, investors can make a large difference to the market value of a company and can do so overnight.

These expectations and changes in the climate for doing business, as in interest rates that help set the cost of capital, are often well beyond the control of managers. Managers should be encouraged by shareholders and investors to maximise EVA, not their share prices or total shareholder returns over which they can have little immediate influence, given the other value-creating or value-destroying forces always at work.

They should not be indulged when by luck more than their good judgment the market takes all share prices higher. Nor should they be penalised when the market turns sour.

Shareholders and their managers with EVA- linked rewards should hope that positive EVA surprises, when sustained, will be appreciated by investors willing to pay up for their shares.

It may take time to convince investors of the superior capabilities of a management team and its business models. But superiority can only be demonstrated by consistently adding economic value and beating the cost of capital.

This article originally appeared on Business Live.