Should an SMB focus more on ROI or EVA?

Depending on the industry and size of co, EBITDA, ROI, ROE and other ratios.

Hi Jeff,

Typically, a Small and Medium Business likes to keep things simple, so they would tend to favor using Return on Investment ratios rather than the Economic Value Added concept. (ROI is often also used to mean the IRR from a DCF calculation but that is not the meaning I use here.) Academics prefer EVA because it can be shown to be equivalent to NPV but practitioners sometimes have difficulty understanding the relative comparison of either EVA or NPV. For example, if I tell you that project A has a 20% ROI while B has a 10% ROI, you can intuitively feel the relative value between the two. However, if I tell you that Project A has an NPV or EVA of 1000 compared to project B of 500, is A really twice as good as B? Oh, did I forget to tell you that both projects have a billion dollars invested? In other words, people have difficulty understanding scale with EVA or NPV.

While ratios are helpful for cross-sectional or time-series comparisons, when it comes to choosing projects, a DCF/NPV approach is still the superior criterion.

Hope this helps. If you'd like to see some readings about EVA, please send me a note.

Jake

The answer varies a little depending on the use...project selection or operating performance evaluation. I like an "EVA lite" approach for operating performance evaluation as it explicity recognizes the cost of equity capital not recorded under accounting rules. The trick is picking the cost of equity capital, including factoring the degree of financial leverage present. For a small/medium business, simple is fairly essential. Certain variations of EBITDA ratios are useful, but more complex for some to follow, and need to compare to an investment measure and provide an "appropriate" or higher return.

Assuming we are using ROI in the sense of Jake's example (IRR et al), the two measures can be related, so it is not an either/or situation. EVA is calculated as the value added over the cost of capital: EVA "rate" = ROI - Cost of Capital. The resulting rate is then multiplied to generate an EVA value (500 or 1000 in the example).

Both are useful indicators and it depends on what you are trying to compare/evaluate over time and for what purpose. In particular EVA depends on a series of adjustments/assumptions that are specific to each organization (for example treatment of R&D expenses) and therefore it could get complicated. If you for example decide that leasing is capitalized in your EVA calculation you will get different figures than if you don't treat leasing in such a way.
What is really important is to evaluate the free cash flow over time originated from the SMB.
In short, both ROI and EVA are useful for specific purposes. EVA might require additional work to provide #transparency and it might reflect the accounting value creation depending on adjustments/assumptions and this should be considered to avoid wrong #decisionmaking.

I agree with Barrett. I like an "EVA lite "approach. I find it allows you to think through the key drivers of the decision without going all the way through all the complexities of an entire EVA calculation. At the end of the day, done correctly the two methodologies should get you to the same place the majority to the time.

I would agree with Georg Fendt. It depends on what you are trying to measure. While ROI and EVA have a focus pertaining to capital, it might not measure the 'heartbeat of your business' like customer churn, lifetime customer value, customer acquisition costs. You need to first define what you are trying to monitor or measure and then choose the most appropriate metric. For example, a ruler and a thermometer are both measurement instruments but one measures space while the other measures temperature.

ROI for capital purchases, profit for overall company (ebitda if it is a private equity firm, eps if it is public, revenue and operating income if it is venture based).