For several decades academics have been looking for an efficient performance measure, which not only reflects the effectiveness and efficiency of the firm, but also aligns manager′s and shareholder′s interests. Even though many studies question the merit of a single measure for overall firm performance, Stern and Stewart claim to have solved the puzzle with a method labeled Economic Value Added (EVA).
This paper examines two aspects: First, EVA′s predicting power regarding stock returns and second, its impact on management behavior as an element of executive compensation.
At first glance, Stern and Stewart seem to be right. During the early 1990s their approach gained tremendous popularity, reflected by dozens of anecdotal success stories. Though EVA′s demand of integrating a total capital charge is appealing, the concept is by no means new. The framework of residual income (economic profit), which has been around for decades, also requires a charge for equity capital. Further, some scholars criticize the use of accounting adjustments in order to calculate EVA and its ability to capture performance at the divisional level.
So far there is no independent empirical evidence that EVA is superior to accounting measures in predicting stock returns. Some studies even question EVA′s incremental value regarding executive compensation by stating that economic profit is doing as good a job.
Consequently, it is tempting to doubt that Economic Value Added indeed adds any value.
Table of Contents
1 EVA AND SHAREHOLDER VALUE
1.1 INTRODUCTION
1.2 EARLIER PERFORMANCE MEASURES
1.2.1 Accounting Measures
1.2.1.1 Return on Capital Measures
1.2.1.2 Earnings Measures
1.2.2 Economic Measures
1.2.2.1 Residual Income / Economic Profit
1.2.2.2 Market Value Added (MVA)
1.2.2.3 Excess Return
1.3 ECONOMIC VALUE ADDED (EVA™)
1.3.1 A Revolutionary Approach?
1.3.2 Accounting Adjustments
1.3.3 Early Euphoria
1.3.4 Advantages of EVA
1.3.5 EVA and MM [O’Byrne (1996)]
1.4 CRITICS AND EMPIRICAL EVIDENCE
1.4.1 Setting the Scene
1.4.2 EVAdence (1993 – 1995)
1.4.3 STEWART (1994) in defense of his label
1.4.4 STERN, STEWART, CHEW (1994) - The EVA Roundtable
1.4.5 PETERSON and PETERSON (1996)
1.4.6 BIDDLE, BOWEN, and WALLACE (1997, 1998, and 1999)
1.4.7 O’BYRNE (1996, 1997, and 1999)
1.4.8 KRAMER and PUSHNER (1997)
1.4.9 CHEN and DODD (1996, 1997a, 1997b, and 2001)
1.4.10 DODD and JOHNS (1999)
1.4.11 BIDDLE, BOWEN, and WALLACE (1999) – In Answer to O’BYRNE (1996)
1.4.12 GOETZMAN and GARSTKA (1999)
1.4.13 GARVEY and MILBOURNE (2000)
1.4.14 Ray (2001)
2 EXECUTIVE COMPENSATION
2.1 EXECUTIVE MOTIVATION
2.2 OBJECTIVES OF EXECUTIVE COMPENSATION
2.3 STOCK PRICE AS A PERFORMANCE MEASURE
2.4 ALIGNMENT OF MANAGEMENT AND SHAREHOLDER INTERESTS – AGENCY THEORY
2.5 WEALTH LEVERAGE
2.5.1 Optimal Contracts
2.5.2 Management Buyouts (MBOs)
2.5.3 Shortcomings of MBOs
2.5.4 Stock options as an alternative to MBOs
2.6 WHY EVA IS BETTER – YOU GET WHAT YOU MEASURE
2.6.1 Flaws of a conventional bonus plan
2.6.2 EVA as a Superior Measure
2.6.3 EVA bonus plans
2.7 LIMITATIONS OF EVA- BASED COMPENSATION
2.7.1 Divisional Performance Measurement
2.7.2 Empowerment
2.7.3 Cultural Differences
2.7.4 Cyclical Industries, Start-ups, Emerging Markets, and Organization Structure
2.7.5 Differences in risk preference
2.8 EMPIRICAL EVIDENCE
2.8.1 Lehn and Makhija (1996)
2.8.2 Wallace (1997)
2.8.3 GARVEY and MILBOURNE (2000)
2.8.4 Other critics
2.9 ALTERNATIVES FOR EVA AS WEALTH LEVERAGE CREATOR
2.9.1 Equity Carve-Outs (ECOs)
2.9.2 Tracking Stock
3 CONCLUSION
Research Objectives and Themes
This dissertation investigates the efficacy of Economic Value Added (EVA) as a performance metric, specifically evaluating its predictive power regarding stock returns and its functional role as a component in executive compensation structures to align management and shareholder interests.
- Comparative analysis of EVA against traditional accounting-based performance metrics.
- Examination of the empirical correlation between EVA and market stock returns.
- Assessment of EVA's utility in mitigating agency problems within corporate governance.
- Evaluation of alternatives for wealth leverage, including Management Buyouts (MBOs) and Equity Carve-Outs.
- Critical reflection on the limitations of value-based management in diverse organizational and cultural contexts.
Excerpt from the Book
1.2.1.1 Return on Capital Measures
Stern (1994) criticizes the use of accounting measures such as return on net assets (RONA). He argues that if a return on capital measure is applied, the management is reluctant to invest aggressively and grow due to the fear of diluting high return rates. Even projects with a return exceeding the firm’s cost of capital are rejected when they would lower the overall RONA of the company. Therefore, the danger is that the company’s RONA becomes the new hurdle rate instead of the firm’s weighted average cost of capital (WACC). Consequently, value increasing projects would be rejected.
A practical example is Apple Computers Inc. In the early 1990s the firm generated RONAs of up to 30 percent. Because management compensation was based on RONA, managers bypassed projects generating a 20 percent return even though the firm’s WACC was much lower [Amelio and Simon (1998)].
Summary of Chapters
1 EVA AND SHAREHOLDER VALUE: This chapter introduces the concept of EVA and its theoretical foundations, comparing it with earlier performance metrics like accounting earnings and residual income.
2 EXECUTIVE COMPENSATION: This section explores how EVA is utilized in incentive contracts to align managerial behavior with shareholder wealth, while also addressing its practical limitations.
3 CONCLUSION: The final chapter synthesizes the findings, noting that while EVA provides a logical framework for internal capital discipline, independent evidence of its superiority in predicting market stock returns is largely absent.
Keywords
Economic Value Added, EVA, Shareholder Value, Executive Compensation, Agency Theory, Wealth Leverage, Residual Income, Market Value Added, MVA, Performance Measurement, Management Buyouts, Equity Carve-Outs, Capital Discipline, Stock Returns, Corporate Governance
Frequently Asked Questions
What is the core focus of this research?
The research evaluates the validity of Economic Value Added (EVA) as an instrument for both measuring firm performance and aligning executive compensation with shareholder wealth maximization.
Which key topics are examined in the study?
The study covers the transition from accounting-based metrics to economic-based metrics, the influence of agency theory on compensation design, and the empirical validity of claims made by EVA proponents.
What is the primary research goal?
The primary goal is to determine if EVA truly adds value in predicting stock returns and whether it offers distinct advantages over simpler measures like residual income in executive incentive schemes.
Which scientific methodology is applied?
The paper employs a comprehensive literature review and a critical assessment of empirical evidence, synthesizing existing academic studies and performance models from the 1990s and early 2000s.
What themes does the main body address?
The main body is structured into two parts: the first evaluates EVA's correlation with stock performance and firm value, and the second analyzes its role in designing executive compensation and the impact of divisional performance measurement.
Which keywords define this work?
The work is characterized by terms such as Economic Value Added, agency conflicts, wealth leverage, residual income, and capital discipline.
How does the author view the "treadmill" effect?
The author highlights the "expectations treadmill" as a phenomenon where market pressures force companies to constantly increase performance levels post-EVA implementation, potentially causing share prices to drop if forecasts are not consistently met.
What is the author's conclusion on EVA's "revolutionary" status?
The author concludes that EVA is not as revolutionary as claimed, noting that it is largely a rebranding of the established residual income framework and that its incremental value over existing accounting metrics remains questionable.
- Quote paper
- Stephan Pietge (Author), 2003, EVA as a measure for shareholder value and executive compensation - A critical view, Munich, GRIN Verlag, https://www.grin.com/document/16993
