The Search for the Best Financial Performance Measure

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The Search for the est FinancialPerformance Measure

Jeffrey M. Bac idore John A. Boquist Todd T. Milbourn and Anjan V. Thakor

Refined economic value added (REVA ) provides an analytical framaoork forevaluating operating performance measures in the context of slmreholder valuecreation. Economic value added (EVA) performs quite well in terms of itscorrelation with shareholder value creation, but REVA is a theoretically superiormeasure for assessing whether a firm's operating performance is adequate from thestandpoint of compensating the firm's financiers for the risk to their capital. In thisarticle, comprehensive statistical analysis of both REVA and EVA is used toestimate their correlatio) with and their ability to predict shareholder value creation.REVA statistically outperforms EVA in this regard. Moreover the realized retumsfor the 1988-92 period for the top 25 R EVA firms were higher than the realizedreturns for the top 5 EVA firms.

n the 1980s, shareholder activism reachedunprecedented levels and led to increased pres-

sure on firms to maximize shareho lder value con-sistently. For exam ple. Time n:\agazine sum ma rizedthis activism as Ang ry investors closed out theDecade of Greed w ith dem ands that executive com-pensation should be tied to company performance(Smolowe 1996). The basic idea is that if ma nage rsare offered compensation contracts that are tied toshareholder wealth changes, their incentives willbe better aligned with those of shareholders than is

the case for other types of contracts. In designingsuch contracts, however, an important issue iswhich me asure of shareholder performance to usein designing the contract.

Tlie obvious metric for judging firm perfor-mance is the stock price itself (see, e.g., Jensen andMurphy 199 and Miiboum 1996). Stock price, how-ever (or returns based on stock price), may not be anefficient contracting parameter because it is drivenby many factors beyond the control of the firm'sexecutives. Moreover, as one moves down the orga-nizational ranks, the inefficiencies of stock-basedcompensation as a means of aligning managerialinterests with those of stockholders become evenmo re evident because managers at lower levels have

Jeffiey M. Bacidore is a doctoral cand idate in finance atIndiana University. John A. Boquist is the Edward E.Edw ards Professor of Finance at Indiana University.Todd T. Milbourn is an assistant professor of finance a tLondon B usiness School. Anjan V. Thakor is theEdward ] . Prey Professor of Banking and Finance at theUniversity of Michigan.

even less impact on the stock price than the CEO.Tying managerial com pensation to stock price mayimpose excessive risk on managers and m ay detractfrom the ability of such compensation to provideincentive for managers to maximize shareholderwealth.

Any financial performance measure used inmanagerial compensation, on the one hand, mustbe correlated highly with changes in shareholderwealth and, on the other, should not be subject toall of the random ness and noise inherent in a

firm's stock price. This dichotom y is the fundam en-tal tension a good performance measure mustresolve. A recent example of a performance mea-sure that seeks to resolve this tension is economicvalue added (EVA). This measure, proposed byStern Stewart Management Services, creativelylinks the firm's accounting data to its stock marketperformance (Stewart 1991).

Before examining the correlation betweenshareholder wealth and a performance measure,one must first define the appropriate way to mea-

sure changes in shareholder wealth. We contendthat shareholders are concerned with the abnormalreturn they earn in any period—that is, the returnthey eam in excess of wha t they expected to earn fora firm within a given systematic risk class. Wlienthis return is positive, shareholders have more thancovered their risk-adjusted opp ortun ity cost of pro -viding their capital. Conversely, when this return isnegative, they have been inadequately compen-sated for risk. Given this relationship, a goodfinancial performance measure should correlatehighly with abnormal stock return s.



In this article, we pre sent an em pirical ana lysisof the ability of EV to predict abnormal return andof the contemp oraneous correlation between EVAand abnormal return . In addition, we define a newperformance measure, a refinement of EVA, andexamine its statistical properties. This new perfor-mance measure, refined economic value added(REVA), comp leme nts EVA in that it could be usedin conjunction with EVA, with the choice of mea-sure dictated by the level of the organization atwhich the performance measure is used. We arguethat REVA is a better measure of performance fortop management, although EVA may be useful atlower levels. O ur em pirical tests are extensive, andwe also focus on nonpar am etric tests of the predic -tive abilities of EVA and REVA.

Although many companies use EVA for bothresource allocation and compensation purposes,virtually no research reported in the published lit-erature provides information about the statisticalrelationship ofEVA toshareholdervalue. One goalof this article is to fill that void. Moreover, muchremains to be learned about alternatives and com-plements to EVA, particularly for managers at dif-ferent levels of an organization. Although ourefforts in this direction are by no mea ns exh austive,we hope that the introduction of REVA is a usefulfirst step.

STRATEGY VALU E AND THE CHOICEOF PERFORMANCE MEASUREAn appropriate performance measure gauges howmanagement strategy affects shareholder value asmeasured by the risk-adjusted return on investedcapital. An appropriate performance measure togauge the effectiveness of a given strategy must,therefore, incorp orate the required rate of return oninvested capital, accurately measu re the am ount ofcapital used by the company, and correlate highlywith the risk-adjusted rate of return earned byshareholders. In this section, we formalize howinvested capital and the required rate of return onthat capital should be m easured , as well as wha t ismeant by an appropriate risk-adjusted return toshareholders.

Figure 1 . The Compo nents of Value

Net Present Valueof Current and

Future Investment* Opportimities

As5ets in Place

Market Valueof Firm

Econoniic BookValue of Assets

Invested Capital Strategy and ValueFigure 1 illustrates the components of firmvalue. The most transparent comp onent of a firm svalue is its physical assets in place: plant and e quip-ment, real estate, working capital, and so forth.Another component is the net present value of thefirm s current and future investment o pportunities.This com ponent s value is less tangible than itsphysical assets, is driv en significantly by the firm sstrategy, and is sizable for many firms. Tlie totalvalue of the firm is the sum of these two compo-nents of value. The question is: How do we deter-mine these values?

The firm s balance sheet contains one mea sureof the value of the firm s assets in place. Considerthe accounting-based balance sheet in Table 1, forexam ple. Because of a variety of accounting distor-tions, the total asset value on the typical balancesheet does not accurately represent either the liqui-dation value or the replacement-cost value of theassets in place. Therefore, it is of limited use forasset valuation purposes and must be transformed.

The proponents of EVA, most notably SternStewart, are careful to adjust this accounting bal-ance sheet before arriving at an estimate of thevalue of the firm s assets in place.^ The a djustme ntsinclude netting the non-iiiterest-bearing currentliabilities against the curre nt assets, addin g back to

Table 1 . Accounting Based Balance Sheet ss ts

Current assetsMet goodwillFixed assets

Total assets

s and d Worth

Non-interest-bearing current liabilities CNIBCLs)Interest-hearing current liabilities (IBCLs)Long-term debtEquity (net of write-offs)

Total liabilities and net wo rth



equity the gross goodwill (i.e., adding cumulativeamortized goodwill back to total assets), restruc tur-ing and other write-offs, capitalized value of R&D(and possibly advertising), LLFO reserve, and soforth. The debt balance is increased by the capital-ized value of operating lease payn ients. The goal isto produce an adjusted balance sheet that reflectsthe economic values of assets in place more accu-rately than the inherently conservative, historical-cost-based balance sheet guided by generallyaccepted accounting principles.

After these adjustments, the typical firm's economic book value balance sheet would lookas it does in Table 2. Although this economic bookvalue balance sheet represents the value of theassets in place more accurately than the balancesheet produced by the firm's accountants, it stilldoes not determine the total value of the firm,which includes the value of future opportunities.

The total value of the firm—the sum of the two

components of value in Figure 1—is also equal tothe market value of equity plus the market va lue of

debt. Thus, the difference between the marketvalue of the firm and the economic book value ofits assets in place represents the market's assess-ment of the value of the firm's current and futureinvestment opportunities. This difference can beconsidered an assessment of the value of the firm'scompetitive strategy and its deploym ent of hum anresources. If we recast the firm's balance sheet inmarket value terms, we have a balance sheet suchas that presented in Table 3.^

The mark et va lue of assets can be either aboveor below the economic book value of the assets inplace. In particular, if the firm executes a poorstrategy in the opinion of the market or if it doesnot possess the human resources needed to imple-ment a good strategy successfully, the market willlower the value of the firm's assets, perhaps belowthe economic book value of the assets in place.

How Much Capital Is Invested in theFirm?

A good financial performance measu re shouldask how well the firm has generated operatingprofits, given the amount of capital invested toproduce those profits. The idea is that the firm'sfinanciers are free to liquidate their investment inthe firm and invest the liberated capital elsewhere.Thus, the financiers must earn at least their oppor-tunity cost of capital on the invested capital. Thiscondition implies that this cost of capital must besubtracted from operating profits to gauge thefirm's financial pe rformance , EVA, for that rea son,defines net opera ting profit after tax (NOPAT) an dsubtracts a capital charge for the economic bookvalue of assets in place. The economic book valueof assets in place is the measure of the capital pro-vided to the firm by its financiers. But does thisamo unt truly represent the capital used to generatethe operating profit?

We beheve the answ er to that question is nega-tive. At the beginning of any period, the financiersas a group could sell the entire firm for its marketvalue. They could then invest their proceeds in assetsidentical in risk to the firm and earn an expectedreturn equal to the firm's w eigh ted-average cost ofcapital (WACC).^ By not liquidating their holdingsin the firm, these financiers are forgoing this oppor-tunity to earn the weighted-average cost of capitalon the m arket value of the firm at the beginning ofthe period.

For the firm to create true operating surplusfor its financiers in a given period, its operatingprofit at the end of the period m ust exceed a capitalcharge that is based on the total mark et value of thecapital used at the beginning of the period, notsimply the economic book value of its assets inplace. The capital com mitmen t of the firm's finan-ciers is represented by the total marke t value of thefirm, not simply the economic book value of the

Table 2. Econom ic Book Value Balance Sheet

ssets Udbilitics ami Net Wortli

Currentasset5(withinventoryatFIFO)—NIBCLs lBCLsGross goodw ill Debt (+ capitalized leases)Fixed assets Equity (+ adjustm ents for deferred taxes,

Economic book value of assets in place

gaodwill amortization, write-offs, LIFOreserves, etc)Total liabilities and net wortli

Table 3. Market Value Based B alance Sheet

ssets

Market vaiue of assets

Total m arket value of assets

i bilities and Net W orth

Market value of debt (including leases)Market value of equity

Total market value of debt and equ ity

Fi i l A l t J i M J 1997 13



assets in place. This investment in the firm in anygiven period constitutes the capital that the firm hasused to produce profits. This perspecfive mofivatesour development of REVA in the next section.

Operating versus Trading BasedPerformance

Measures of shareholder wealth creation focuson the firm's stock price performance and seek todetermine how much shareholders increase theirwealth from one period to the next based on thedividends they receive and the appreciation in thefirm's stock price. Essentially, such trading-basedperformance measures assess how well an investorwould have done if he or she had purchased a shareof stock at the beginning of the period and sold itat the end. This type of measure of shareholderwealth creation is called a trading-based measure

of performance. In contrast, performance measuressuch as EVA focus on the firm's operating perfor-maaice from the standpoint of its financiers.

An operating measure of current performancefocuses solely on the performance of the firm in agiven period; a trading-based measure of perfor-mance captures revisions in the market's beliefsabout the firms's entire future stream of operatingperformances. If stock markets are efficient and weexamine a sufficiently long time horizon, these twomeasures will converge. We usually assess perfor-mance over shorter horizons, however: a year, a

quarter, or a month. Therefore, any operating mea-sure of performance will diverge somewhat from atrading-based measure of performance. Obviously,we do not want to use a trading-based measure ofperformance for conripensafing all of our managers,particularly those at lower levels of the organiza-tion, whose decisions have less impact on stockprice. We do, however, want a measure of perfor-mance to be a barometer of shareholder wealthcreation against which we can judge the efficiencyof any operating performance measures.

Shareholders can earn a return on their invest-ment in two ways; through dividends and throughcapital gains. Over any period of time, t, the share-holder return for firm / can be specified as

D t P P \ \r ; — r : , J

(CAPM) captures the first two factors by specifyingthat the expected return on a stock investment is

j . I l

where Dj; is the dividends paid during the periodf - 1 to f and Pjf is the price of the shares at the endof period t.

Many factors influence Rj j most notably, therisk of the investment, the interest rates prevailing

in the capital markets, and the expertise of thefirm's managers. The capital asset pricing model

where

Rj = the risk-free bond yield at tim.e t

P = firm /'s beta, a measure of thefirm's systematic risk

E{Rmi) - R = the expected equity market riskpremium, usually taken as thelong-run, average realized returnon the market in excess of risk-freebond retums

The CAPM thus helps to determine the abnormalreturn firmy earned in period t. We call this returnalpha and calculate it as

Thus, a , measures the actual shareholder returnin excess of the return that was expected in a period,given the firm's systematic risk. In that sense, thereturn is abnormal. Alpha, we propose, is thus theappropriate measure of shareholder wealth cre-ation in any given period. Consequently, alterna-tive operating performance measures will bejudged by their correlation with this abnormalreturn.

This measure is indeed a high hurdle for per-

formance. One would not expect a large number offirms to achieve positive abnormal returns formany periods. In fact, because a firm with a stringof positive alphas is one that continues to produceshareholder returns in excess of the risk-adjustedexpected return, this firm is consistently beadngmarket expectations. Firms that perform this wellare truly exceptional and quite rare. The question,then, is: What operating measure of performancecorrelates highly with tliis measure of shareholderwealth creation?

REVA AS A HIGH LEVELPERFORMANCE MEASUREThe operating measure of performance shouldobviously capture how well a given company hasperfornied in terms of operating income. Net oper-ating profit after taxes alone, however, is not anappropriate measure because it neither captureshow much capital is used to generate a given levelof income nor accounts for the required rate ofreturn on invested capital. Tl ius, an appropriateperformance measure is one that includes net oper-

ating income after taxes, the amount of capitalinvested, and the required rate of return on capital.



What Is REVA?EVA is defined asEVA = NOPAT-fc^. (1)

where k^ is the weighted-average cost of capitalan d NA is defined as adjusted book value of netcapital at the beginning of the period.

In Equation 1, NOPAT is defined as reportednet operating profits plus any increase in bad debt

reserve plus any increase in the LIFO reserve plusamortization of goodwill plus any increase in netcapitalized R&D plus other operating income(including passive investment income) minus cashoperating taxes.

A firm's weighted-average cost of capital inEquation 1 (WACC k^^ is derived from the follow-ing formula:

M

•W^^M 2)

'Af

whereDj^ - market value of the firm's total debt

EjVi = market value of the firm's total equity

kjj - pretax cost of deb t

T = the firm's marginal tax ratekj: = cost of equity

A firm 's net asset base in Equation 1 is defined by acompany's total assets minus non-interest-bearingcurrent liabilities, with the adjustments discussed

earlier. That is, net assets represent the total eco-nomic book value of the firm's assets in place.The motivation for the REVA refinement to

EVA stems p artly from EVA's use of the economicbook valu e of assets when the capital charge for thefirm is derived from a market-based WACC. Tomake inferences about changes in shareholderwealth, a market-derived cost of capital should beapplied to the market value of the firm's assets.Thus, the RHVA for a g iven period t is defined as

REVA, = NOPAT,-;-,^,(MV,_j), 3)

where NOPATf is the f irm's NOPAT at the end ofper iod t and MWj_i is the total market value of thefirm'sassetsat the en d of pe rio d t-l (beginning ofperiod 0. MV^.^ is given by the market value of thefirm's equity plus the book value of the firm's totaldebt less non-interest-bearing current liabilities, allat the end of period t-l.

EVA and REVA ComparedThe key distinction between EVA and REVA is

that REVA assesses its capital charge for period t

on the market value

of the firm at the end of period

^ - 1 (or the beginning of period 0 rather than onthe economic book value of the assets in place.

The following example highlights the potentiadifferences in the shareholder w ealth implications ofEVA and REVA, Suppose an investor holds one sharof XYZ Com pany stock at the beginning of the yearThe stock is currently trad ing at 50 a share, and theeconomic book value of the stock is 40 a share.'Suppose that the investor and the rest of the markeexpect this stock to eam 10 percent over the next yeaThe investor expects this 10 percent return on the 50market value of the firm, not its 40 economic boovalue . That is, the investor expects a payoff of 5 share, not 4. The contrast between EVA and REVAcan now be seen in this context. Suppose the firm icompletely equity financed. With all-equity financing, the WACC for this firm is simply its cost ofequity of 10 percent. Further assume that the firmhas TOO shares of stock outstanding at the beginninof the year (period t 0). Therefore, the economicbook value of the firm s 100 times 40, or 4,000, andthe market value of the firm is 100 times 50, or 5,000, at / = 0. If during the year the firm generatesa NOPAT of 450 on the firm s nvested capital, howhas the firm done in terms of EVA and REVA?

The firm has genera ted an EVA at time t-loi

EVAT = NO PA Ti - ( 4,000 x 10%)

= S450 - 400

= S50,

According to the EVA perspective, this firm hascreated 50 of value for its shareholders. Now , con-sider the firm 's REVA:

REVAi = NOPATj - ( 5,000 x 10%)= 450 - 500

- -S50,

According to REVA, this firm has destroy ed 50 inshareholder value.

Should the firm's management be satisfiedwith its performance over this period? It has generated a positive EVA and a negative REVA. The firm,with a cost of capital of 10 percent, has produced an8 percent return on the market value of its assets anda n i l .25 percent return on the economic book valueof its assets. Because an investor in this firm couldhave taken his or her 50 a share and invested it inanother company of equivalent risk to generate the10 percent required return, the NOPAT of 8 percentof the market value of the firm is, in our view,inadequate compensation.

This example, although simple, illustrates howa firm could be delivering less in terms of operatingeamings than the shareholders require and yet

appear to be creating shareholder value based on



EVA . Tliis possib ility is the first justification forusing REVA.

Flows to Equity versus Total Flows to ll Financiers

Ano ther difficul ty with EVA provid es a secondjustification for usi ng REVA. Co ncep tually , EVAshould be the same regardless of whether we useNOPAT and the WACC or (adjusted) net incomeand the equ ity cost of capital. Ho we ve r, as w eshow belo w, there is no such equivalence whe n themarket value of a firm differs from its book value.

The f lows to equity-based EVA are defined as

EVAf(Equity flows) = Net inco me, - k^iE ,

where net income is s imply the NOPAT less thefirm's after-tax interest expense and £ is the eco-nom ic book value of equity. We can then w ri te

Net income = NOPAT , - ^^ 1 - T>D,

wh ere D is the economic book value of debt . There-fore, we should have

EVAf(NOPAT) = EVA,(Equity flows). (4)

Expanding both the lef t hand side and the r ighthand side of Equation 4 yields

NOPAT^-k^^, NA,_•^ = Net income-A -^(£). (5)

Dropping the t ime subscripts and recognizing thatNet income ^ NOPAT - kijd - T D, we can wri teEquation 5 as

•AD

= Net income-/:/j(1 - 7 )£'-A'£(£').

Therefore, for the equivalence to hold, D ^ mu stequal D and j^ must equal E . That is, the marketvalues of debt and equity should be equal to therespective economic book values. It is unc omm onfor the ma rket valu e of equity to be precisely equ alto the economic book value of equity, primarilybecause market value includes an estimate of thevalue of future opportunities. This conceptual dif-ficulty does not exist with REV A, prim arily becau seit relies on the market value of capital.

We can thus sum ma rize two key advantage s ofREVA relafive to EVA. First, whenever REVA ispositive, incremental shareholder value has beencreated. The operating income flowing to financiersat the end of the period as a percentage of themarket value of their investment at the beginning

of the period exceeds their oppo rtun i ty cost of cap-ital. This condition does not hold for EVA—thefinanciers could be receiving an operat ing -incom e-based retu rn that is less than their op po rtun i ty costof capital even wh en EVA is positive. Second, REVAcan be comp uted based o n total operafing f lows todebt and equity or only on the f lows to equity. This

capabil i ty is t rue for EVA only when the marketvalues of debt and equity coincide with theirrespect ive economic book values.

Organization Level and Choice ofFinancial Measure

REVA is a more appropria te performance m ea-sure than EVA when considering the sharehold ers'view of the firm. He nce, the senior executives in thefirm (e.g., the CEO and o ther me mbe rs of the exec-utive committee) should be evaluated on the basis

of the firm's REVA performance. The firm's valuederives both from its physical assets in place andits strategy with respect to future opportunifies.Both of these values are the appro priate domain ofthe firm's senior executives. The market value ofthe firm—which is a component in REVA—includes the values of both the physical assets andthe strategy, whereas the economic value of thefirm—which is a component in EVA—representsonly the va lues of the physical assets in place. Strat-egy is the primary responsibility of top manage-ment. The firm's economic value is an adequaterepresentation of invested capital from the stand-point of those below top m anagem ent. Thus, REVAcould be used to compensate senior managementand EVA could be used to compensate divisionalmanagers and those below them.

EMPIRIC L N LYSISThe empirical analysis used the Stern Stewart Per-formance 1000 datab ase for the yea rs 1982 throug h1992. We ran dom ly selected 600 of the 1,000 firm sin the database and proceeded to calculate each

firm's EVA, REVA, total shareholder return, andrisk-adjusted abnormal return for each year. Thesecalculations involved matching the 600 firms tocorporate financial data for those years. Allaccounting and financial market data were takenfrom S tandard & Poor's Compustat and the Uni-versity of Chicago's CRSP databases, respectively.

Calculafing a firm's yearly EVA and REVArequires estimates of its NOPA T, WACC, economicbook value of assets, and market value of assets. Inour calculation of REVA, we used the NOPAT dataprovided by the Stem Stewart database. The market

value of capital was estimated by sum ming the mar-ket value of equity, book value of interest-bearing



liabilities, and book value of prefer red stock. Bookvalues were used for debt and preferred stockbecause market values for these variables are notavailable. - The WACC was estimated as theweighted average of the cost of equity, debt, andpreferred stock, where the weights are the market-based capital structure weights obtained from thecapital structure com ponents. To estimate the firm scost of debt, we assigned the bond yield as reportedin Standard Poor s Indu strial Bond Guide for com-mensurate bond rafings. The after-tax cost of debtwa s estimated by m ultiplying the firm s cost of debtby its marginal tax rate, which was estimated bydividingthere ported tax expenseby the firm s pretaxincome. The cost of equity w as estimated using theCAPM, The cost of preferred stack wa s estimatedas the average of the cost of equity and debt.

To dete rmin e the cost of equity, estim ates of therisk-free rate, the expected market risk premium,and the firm s beta are ne eded. The yield to m atu-

rity of a one-year discount bond taken from theCRSP Fama-Bliss files was used as a proxy for therisk-free rate. To gauge the expected market riskpremium, historical averages of realized annualmarket risk premiums from 1926 to the ) ear priorto the observation year were calculated. The real-ized market risk premiums were taken from Tbbot-son Associates, 1995 earbook of Stocks Bonds Billsand Inflation. Eirm betas were calculated us ing themethodology outlined by Fama and French (1992).This methodology involves first assigning allNYSE, Am ex, and Nas daq firms available on CRSP

to 10 size-based portfolios. Each size portfolio isthen portioned into 10 beta portfolios. The m onthlyretu rns of each of the 100 equally w eighted portfo-lios we re used to estima te the portfolios betasusing the techniques outlined by Dimson (1979).The portfolio beta wa s assigned to each firm w ithinits portfolio a nd u sed to calculate the firm s cost ofequity.

EVA was estimated using NOPAT and the eco-nomic book values of capital from Stern Stewart,and the WACC used to calculate REVA was also

used to re-estimate EVA. This step wa s to isolate thetrue difference between REVA and EVA—that is,the different capital bases. Using different W ACCscould provide results driven solely by the m ethodused to estimate WACC and, as a result, wouldcloud the true underlying relationship between thevariables in qu estion. ^

Empirical Resuits. Hozv well do EVA and REVA correlate with

shareholder wealth creation? Th e first set of te stsinvolved regressing the CAPM-based abnormal

return s of each security on var ious c ombinations ofEVA and REVA measures to determine how welleach performance measure explains abnormalretums—that is, retums over and above theexpected retvim. Both EVA and REVA we re scaledby the ma rket value of equity to create two new vari-ables, EVARET and REVARET. This step w as d oneto make both variables consistent with the abnorm alreturn variable, which wa s measu red as a percent-age. The market value of equity was u sed becauseboth EVA and REVA gauge the value creation forshareholders. First, we regressed abno nnal returnson EVARET and REVARET individually. Ourresults indicate that, on an individual basis, bothEVARET and REVARET are positively related toabnormal retums at the 1 percent significance level(see Table 4). A1 percent increase in H VARET resultsin a 0.27 percent increase in abn orma l retu rns. Sim-ilarly, a 1 percent increase in REVARET leads to a0.58 percent increase in abnormal retums. There-

fore, on averag e, an increase in either EVA or REVAleads to an increase in shareholder wealth.

What about past EVAand REVAaspredictorsoffuttire abnormal returns? Our next set of testsinvolved adding lagged values of EVARET andREVARET into the abnormal retums regressions.These tests examined whether past realizations ofEVA and REVA have a significant effect on abnor-mal retum s. In the regression of abnormal returnson EVARETand lagged EVARET, EVARETissignif-icantly positively related to abnormal retums and

lagged EVARET is significantly negatively related toabnormal retum s (see Table 5). In a mulfiple reg res-sion framework, the coefficient on lagged EVARETrepresents the sensitivity of abnormal returns tochanges in lagged EVARET, which are unc orrelatedwith contemporaneous EVARET. Similarly, thecoefficient on EVARET measures the sensifivity ofabnorm al return s to changes in EVARET, which areuncorrelated with last period s EVARET. Thus, thecoefficient on EVARET represents how abnormal

Table 4 Abnormal Returns as Explained byEVARET and REVARET f-statistics in p arentheses)

Coefficient

Intercept

Abnormal re turn

EVARET

11,12047

(16,683)*

0,26620

(5,942)**

0.0114

REVARET

0,16232

(19,366)**

0.57997

(11.212)*

393

Note: Sam ple sizi? - 3,076.

**Significant at the 1 percent level.

Financial Analysts Journai • iViay/June 1997



Table 5 Abnormai Returns on Contemporaneous and Lagged EVARET andREVARET

f-statistics in parentheses)EVARET REVARET

Coefficient C urrent Lagged C ur ren t Lagged

bi tercept

Abnormal re turn

0,11969

(15,357)**

0,47639 -0,12918

(6,555)** (-1.819)*

0,0205

0.16549

(16.138)'*

0.75111 -0,10277

(9.588)* -1,408)

0.0396

Nate; Sample size = 2,574,

Significant at the 10 perc ent level,**Significant at th e 1 perce nt level.

returns vary w ith unexpected changes in EVA, whereexpectations are based on the previous period'sEVA, The results above are con sistent if one assu mes

that the market uses EVA not only to assess abnor-mal returns this period but also to predict futureperformance. If the firm has a large EVA this period,the market may revise its valuation of the firmupward significantly, refiecting revised expecta-tions about future profitability. If the niarket'sbeliefs are not confirmed in the next period, how-ever, the value of the stock could fall. Thus, eve n if afirm has a positive EVA this period , the stock maynot eam positive ab norma l reti.irns.

The first key implication of this analysis is thatthe market appears to reward unexpected increases inEVA and bases expecta tions of future profitability onthis period's EVA. The second key implication is thatEVA may bo inappropriate to use as a compensationmeasure for top managem ent because the market isreally rewarding oiily the unexpected porfion of EVA.Basing conipensation on total EVA may result inrewarding managers for subpar performance.

A similar regression was run using REVARETand lagged REVARET. The coefficient on co ntem-poraneous REVARET is again significant, a lthou ghlagged REVARET is insignificant (see Table 5).

This result highlights a key empirical difference

betw een REVA and EVA. REVA is posifively rela tedto abnormal returns, but any revaluafion based onpast period's REVA is impo unde d into contempo-

raneous REVA directly; this result occurs becauseREVA is a function of the market value of equity. Apositive REVA in a given period that leads to revi-sions in the mark et's expectations regarding futureperformance will raise the hurd le by increasingthe market value of equity a nd, as a consequence,next perio d's capital charge. Thus, REVA is a m oreappropriate compensation measure because it is atruer measure of whether the firm has surpassedthe market's expectation and thereby add ed sha re-holder value.

We also regressed abn ormal re turns on EVARETand RE VA l^T simultaneously. Tlie purpo se of sucha regression was to determine which performancemeasure does better in explaining a firm 's abnomnalreturns when the impact of the other measure isaccounted for. The coefficient on REVARET is againsignificantly positive; the EVARET coefficient is nowsignificantly neg tive (see Table 6). This result indi-cates that REVA contains information not cap turedill EVA that is relevant for predicting abnormalretums and that increases in EVA that are uncorre-lated with changes in REVA result in significantly

lower abnormal returns.Table 6 Abnorm al Returns as Explained by Both EVARET and REVAR ET

f-statistics in parentheses)Coefficient EVARET REVARET

Intercept

Abnormal retiurn

0,16746

(19-642)**

-0.20407 0.75450

(-3.162) (9.981)**

0,0424

Note Sample size = 3,076,

' Significant at the percent level.



In summary, EVA is significantly related toabnorma l returns. As show n in Table 6, however, theinformafion provided by REVA subsum es the infor-ma tion implied by EVA realizations. Therefore, con-sistent with the theory, REVA better explainschanges in shareholder wealth and also manage-ment performance at the top level of the firm.

Nonlinear Relationships Estimation* Hozv often does a positive REVA (EVA) predict

a positive excess return? O ne potential problem w iththe regression analysis is that both REVARET andEVARET may be related to abnormal returns in ahighly nonlinear m anner. An additional methodol-ogy was used to account for any nonlinearities:nonparametric tests to capture how well REVA andEVA predict the sign of the abnormal retum s. Thisapproach is equivalent to calculating the probabil-ity that given that a firm has a positive EVA (orREVA), the firm generates a posifive abnormalreturn.

Our test involved splitting the sample into twogroups: those with positive EVA and those wi tli zeroor negative EVA. The proportion of observations ineach group that had positive abnormal retums wasthen calculated, If EVA is a good predictor of abnor-mal returns , the proportion of firms ha t experiencedposifive abnormal retums in the positive EVA sub-sample should exceed the proportion of firms thatexperienced positive abnormal retums in the nega-tive EVA subsample. In other words, Probiabnormalreturn > 0 given that EVA > 0 should be greater than

ProHabmmnal return > 0given that EVA < 0). W e foundthat 68 05 percent of the positive EVA sam ple exhib-ited positive abnornial returns whereas only 56.01percent of the negative EVA sam ple exhibited posi-tive abnorma l retum s. This procedu re was repeatedusing REVA. Positive REVA iniplied a positiveabnorma l retu rn 77.22 percent of the time; a negativeREVA im plied a positive abnormal return o nly 58.48percent of the time.

These results indicate that the proportion ofpositive REVA that correspond to positive abnor-mal returns is significantly higher than the same

prop ortion for EVA. Thus , although EVA on itsown predicts abnormal retums fairly well, REVAperforms significantly better. This finding isimpo rtant because senior managem ent should seeka performance mea sure w ith the greatest ability topredic t correctly directional changes in share holde rwea lth. Our results iniply that REVA serv es both ofthese roles, as displayed in Table 6 and in the non-param etric tests.

' • How do REVA and EVA stock portfolios per-form? Our extensive empirical tests docunient thatEVA on its own can predict changes in s hareholde r

we alth. The simpler me asure , REVA, goes even far-ther, however, REVA app ears to include all informa-tion relevant to a firm's abnormal retum that iscontained in EVA. Moreover, the statisfical pow er ofREVA holds up over long time horizons and out of

saiTiple tests. We formed three portfolios of stocksfrom our sam ple on the basis of the top 25 EVA firmsover the 1982-87 period, the top 25 REVA firms overthe same period, and a value-weighted m arket index

for the same period. We then examined the totalportfolio return over the 1988-92 time period. Theresults of this process, show n in Table 7, documen tthat the high-performance REVA firms outper-formed both the high-performance EVA firms andthe market index.

CONCLUSIONThis analytical framew^ork for evaluating operat-ing performance measures in the context of share-holder value creation indicates that the mostappropriate measure of shareholder value is thereturn shareholders eam through price apprecia-tion and dividends in excess of that required tocompensate shareholders for systemafic risk. Weconclude that EVA does quite well in terms of itscorrelation w ith this me asure of shareholder va luecreation.

EVA, however, views the economic book v alueof the physical assets in place as the capital finan-ciers commit to the firm. We propose that a moreappro priate measure of the capital used in the firmfor any period of time is the niarket value of the

firn^ at the beginning of the period. This approachled us to a refinement of the EVA me asure , REVA,REVA assesses a capital charge for a period equalto the weighted-average cost of capital times themarket value of the firm at the beginning of theperiod. This premise pe rmits com putation of REVAusing either flows to equity or flows to all finan-ciers, wh ich is not possible with EVA unless marketand ecoiiomic book values happe n to be equal bychance.

We conducted a comprehensive statisticalanalysis of both EVA and REVA to estimate theircorrelation with and ability to predict sha reholdervalue creafion. REVA statistically outperform s EVAin this regard. M oreover, the realized retu rns for thetop 25 REVA firms were higher than the realized

Table 7 Portfolio Analysis of EVA and REVA percentages)

I 'ortfolio Total 1988-92 Portto lio R etum

Top 25 EVA firms (1982-87)

Top 25 REVA firms (1982-87)

Value-weighted market index

15.804

17.013

12,861

Financiai Anaiysts Journai • May/June 1997 18



returns for the top 25 EVA firms for the 1988-92period. We concluded that REVA could be used tocompensate senior executives and EVA could beused to compensate those at lower levels in an

organization. Euture research in this area shouldaddres s the important issues of optimal co mpensa-tion design using both EVA and REVA for firms ofhierarchical organ izational ^

NOTESNoise trading, portfolio insurance, and other factors unre-lated to the firm's performance may induce randomness instock prices. See Milbourn (1996) for a theoretical and em-pirical examination of some of these issues.The theoretical statistical expectation of the abnorm al return

3 Articles in the popular pre ss have mentioned the correlationofEVA tomeas uresofshareho ldervalue,but the underlyingresearch has not been reported.

4. Stem Stewartconsidersmo rethan250accountingadjustm entsin moving to EVA, In practice, however, most firms find thatno more than 5 adjustments are of material significance,

5. For nonpubh cly traded firms or divisions, a typical ratio ofmarket value to book value for comparable firms could beused to convert existing book values into market values.

6. That is, the firm's w eighted-average cost of capital is definedas the financiers' oppo rtunity cost of capital,

7. This disparity between economic book value and m arketvalue is representative of the sample of firms used in oursubsequen t em pirical analysis. Specifically, we do cume nt anaverage ratio of adjusted economic book value to marketvalue to be 78.19 percent,

8. Finance compan ies, for example, may find it appro priate touse this flows-to-equity approach,

9. As recommended in the calculation of EVA and as we defineREVA in Equa tion 3, we did not include a firm's non -interest-bearing current liabilities.

10. Following most finance researchers, we assumed that the book

valuesofde btand preferred stockapproximate market values,11, See Sharpe (1964).12, See Ibhotson (1995).13, As in Fama and French (1992), we estimated beta as the sum

of the slope coefficients in a regression of portfolio returnson the contemporaneous market return and one-periodlagged market return,

14, We chose to re-estimate the WACC for each firm each yearbecause the WACCs reported in the Stern Stewart Perfor-mance 1000 are based on rolling three-year averages.

15, Because beginning-period market value of equity appearsin the denominator of both the independent and dependentvariables, the independent and dependen t variables may be

spuriou sly co rrelated. As a result, one might find a signifi-cant relationship between the independent variables andabnurmal returns even if the underlying variables are un-correlated. Because the market value of equity unde rgoes anonlinear transformation, however, the spurious correla-tion should be reduced. To control for any residual s purio uscorrelation, we ran instrumental variable regressions inwhich the lagged values of EVARET and REVARET wereused as instruments. The conclusions drawn from the in-strum ental variable regressions were qualitatively the sameas those draw n from the ordinary least squares regressions,

16, Both ofthese differences aresignificant at the percent level,17, This difference is significant at the percent level,18, These nonparametric results fortify our intuition that a firm

could have a positiveEVA and stillbedes troying shareholdervalue,

19, We would like to thank W. Van Harlow III for his helpfulcomm ents on an earlier draft of this article.

R F R N S

Dimson, Elroy. 1979, Risk Measurem ent When Shares AreSubject to Infrequent Trading. Journal of iimucint Economicsvol. 7, no. 2 (June):l97-226.Fama, Eugene F., and Kenneth R, French, 1992, The Cross-Section of Expected Returns, journal of finance vol, 47, no, 2(June):427-65,

Ibbotson Associates, 1995. 1995 Yearbook of Stocks Bonds Billsand Inflation. Chicago: Ibbotson Associates,

Jensen, Michael, and Kevin Murphy , 1990, Performance Payand Top-Management Incentives, journal of Political Economyvol, 98, no, 2 (April) :225-62.

Miiboum , Todd T, 1996, The Executive Com pensation Puzzle:Theory and Evidence, IFA Working Paper No, 235, LondonBusiness School.

Sharpe , William F, 1964, Capital Asset Prices: A Theo ry ofMarket Equilibrium under Conditions of Risk, journal ofFinance vol. 19, no . 3 (Ju]y):425-42,

Smolowe, Jill. 1996. Reap as Ye Shall Sow,Time vol, 147, no.6 (February 5):45.

Stewart, G, Bennett UI, 1991. Th e Quest for Value. New York:Harper Business



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The Search for the Best Financial Performance Measure