EVA as a measure for shareholder value and executive compensation - A critical view

Bachelor Thesis 2003 83 Pages

Business economics - Investment and Finance







List of TABLES

1.1 Introduction
1.2 Earlier Performance Measures
1.2.1 Accounting Measures Return on Capital Measures Earnings Measures
1.2.2 Economic Measures Residual Income / Economic Profit Market Value Added (MVA) Excess Return
1.3 Economic Value Added (EVAÔ)
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 the 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)

2.1 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


Appendix accounting adjustments



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.

Words (excluding abstract): 13,242


For their support I would like to thank Carol Peterson and Becky Smith with the Interlibrary Loan Services at Central Washington University.

Since students do not have to write an undergraduate dissertation in the U.S.A., I am grateful for the appreciation my professors at Central Washington University have shown for the project.

Special thanks go to Ted Finch at Napier University Edinburgh, who has advised me during my year abroad; and Jim Mallon, who agreed to supervise my dissertation on such a short notice.


Hereby, I ensure that this paper is my own original work. Where I used external material, I quoted the sources accordingly.

Stephan Pietge Ellensburg, WA, April 24, 2003


illustration not visible in this excerpt


Figure 1: When positive MVA destroys value

Figure 2: Relationship between net income, NOPAT, residual income, and EVA

Figure 3: CEO Turnover Rates

Figure 4: Desired impact of an EVA- based compensation plan

List of TABLES

Table 1: EVA and relative information content

Table 2: EVA’s correlation with levels of MVA and changes of MVA

Table 3: EVA’s explanatory power of stock returns

Table 4: EVA’s correlation with firm value

Table 5: Impact of RI-based compensation on managerial behavior


1.1 Introduction

Firms increase shareholder value[1] when they invest in projects that provide positive net present values (NPV). However, companies not only need a framework that allows them to value new investments, but also a performance measurement system that aligns manager’s and shareholder’s interests.

While capital markets value companies and investments on the basis of future expectations, performance measures and incentive compensation must be based on the past. Therefore, a valuable framework has to take both future expectations and past performance into account. While free-cash flow is a good measure for the feasibility of an investment, it falls short on measuring performance. However, any metric should provide a link to free-cash flow methods to ensure that performance evaluation is consistent with the way investors value the company.[2]

The search for the optimal performance measure has been going on for decades. So far dozens of concepts and frameworks have been developed, which answered some questions but simultaneously raised new concerns. The New York based consulting firm Stern Stewart and Co. claims to have the answer in form of their concept labeled economic value added (EVA).

1.2 Earlier Performance Measures

1.2.1 Accounting Measures 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)]. Earnings Measures

Due to the prominent role of accounting earnings in security analysis, assessing the usefulness of earnings to investors has become the most concerted research effort in accounting history. Pioneered by Ball and Brown (1968), accounting researchers have produced numerous studies investigating the empirical relation between security returns and accounting earnings [see Lev (1989) for a summary of the research].

Earnings as a performance measure are heavily criticized as being subject to manipulation and not considering the cost of equity. However, the focus on earnings is not a surprising phenomenon since most investors are concerned about a company's ability to produce long-term earnings and dividends.

Many different valuation models developed by the investment community include earnings as a primary input [Foster (1986), Lev (1989)]. For better or worse, the Price-Earnings (P/E) ratio is one of the more frequently cited financial indicators in the stock market. Consequently, many managers, in response to the investment community's concern, rely on accounting earnings as a primary measure of corporate performance. Kramer and Pushner (1997) point out that “the market being fed almost constant news on earnings,” it is apparent that investors and analysts are responsive to these measures.

1.2.2 Economic Measures Residual Income / Economic Profit

To overcome problems associated with earnings-based measures, academics propose a concept called residual income (RI) or economic profit (EP).[3] The metric can be related back at least to the late 19th century and the work of Alfred Marshall (1890).[4] Some academics go a step further and trace the concept back to Adam Smith [Mepham (1980)]. Even Hamilton (1777) provided an early reference to the need of a capital charge.

The first application of an economic-profit approach is supposed to be the introduction at General Motors under Alfred Sloan in the 1920s [Stern, Stewart, and Chew (1994)]. However, the framework did not gain popularity before promoted by Solomons (1961 and 1965). Solomons recognized that rates of return, taken in isolation, ignore the scale of operations and forget to focus on the return itself. Residual income takes into account the total cost of capital (debt and equity). As an ex post measure of performance, a rate of return might be appropriate, but as a managerial incentive to proper decision making it does not necessarily lead to investing in all projects with positive net present values (see example Apple Computers Inc). Solomons claims that residual income is the correct measure to both encourage value maximizing behavior by managers and to evaluate performance and indeed, the model is widely accepted in the academic world [Kaplan (1982), Horngren and Forster (1987)]. The RI metric can even promote goal congruence between divisions and the company as a whole [Horngren, Foster, and Datar (1997)].

As shown, the concept is by no means new. And also throughout the 20th century the concept of residual income has been around in the academic world under different labels [ excess earnings by Canning (1929) and Preinreich (1936, 1937, 1938); superprofits by Edey (1957); excess realizable profit by Edwards and Bell (1961); excess income by Kay (1976); and abnormal returns by Peasnell (1981 and 1982); and Feltham and Ohlson (1995)].

Residual income is calculated by deducting a capital charge for debt and equity capital from a firm’s net operating profit after tax (NOPAT):

RI = NOPAT – Cap (WACC) (1)

RI = Residual income

Cap = Invested capital

WACC = Weighted average cost of capital Market Value Added (MVA)

Stewart (1994) proposes the concept of market value added (MVA) as the correct measure for shareholder wealth. He further articulates, the mission of the company is not to maximize its market value but rather its market value added [Stern, Stewart, Chew (1994)]. Kramer and Pushner (1997) agree with regarding MVA as a useful market indication by representing the difference of invested capital and the present and future value of the cash flows expected from the capital.

MVA is the difference between the market value (MV) of the firm (including equity and debt) and the total capital invested in the firm (Cap):[5]

MVA = MV – Cap (2)

MVA measures the cumulative value added (or destroyed) since the interception with the company, unaffected by the period of observation. If its MVA is positive, a firm is creating value, hence, MVA should be maximized. This concept states clearly that growth does not necessarily create value if growth is solely based on higher capital investments. A firm can increase its market value by investing ever-increasing amounts of capital. This is also the case when these new projects do not provide a positive NPV but only recover the cost of capital (zero NPV). Both firm value and capital are increased but MVA is unchanged [Young and O’Byrne (2001)].[6] Growth that is based on a return over the cost of capital is referred to as profitable growth.

Though this concept seems to be appealing, it is not groundbreaking new. Ravid sees parallels to Tobin’s q[7] [Stern, Stewart and Chew (1994)[8] ]. Further, the concept of MVA has a major drawback: opportunity costs of capital invested in the company are not considered. Market value added simply reflects the difference of invested capital and current market value at one point in time. If the market value is greater than invested capital, MVA is positive and indicates the firm created value. However, for an investor it is relevant, what he would have earned by investing in another asset over the same period of time. Consequently, a positive MVA is not identical with wealth creation, when the firm did not compensate the investor for the investment opportunity forgone:

illustration not visible in this excerpt

Figure 1: When positive MVA destroys value

Another problem is that MVA fails to take into account previous cash returns to shareholders. And finally, Birchard (1994) argues that MVA can be biased against low-return start-up investments and can favor businesses with heavily depreciated assets. Thus, the approach leaves many questions unanswered. Excess Return

The concept of excess return (ER) overcomes some problems of MVA by charging the firm for the capital it has used since the beginning of the measurement period (N). ER credits companies for the opportunity costs its shareholders incurred and is defined as the difference between actual and expected wealth of shareholders:

ERN = actual wealthN – expected wealthN (3)

Even tough the equation looks simple, the method has various shortcomings. Changes in invested capital caused by new share issues and share repurchase result in distortions. Further, Young and O’Byrne (2001) show a strong relation (correlation coefficient of 0.9) between MVA and ER for companies in the S&P 500[9], which leads to the assumption that both metrics have similar shortcomings. Indeed, both excess return and MVA are not suitable tools for motivating and evaluating managers. First, they can be calculated only for publicly traded companies and are, therefore, not effective in measuring performance for lower-level management. Second, both MVA and ER are “stock” measures reflecting wealth as of a certain point in time. However, only flow measures are able to track performance over a period of time.

Consequently, the need for a performance measure that is observable at a divisional level, promotes shareholder wealth creation, and measures performance over a period of time, is evident. For some scholars the concept of economic value added (EVA) is the solution.

1.3 Economic Value Added (EVAÔ)

1.3.1 A Revolutionary Approach?

Various academics[10] argue that the concept of economic value added is closely aligned with Solomons’ (1961) model of residual income [Wallace (1997); Goetzmann and Garstka (1999); and Simons (1999)]. Consequently, the label is not as revolutionary as claimed by its creators at Stern Stewart and Co.[11]

The major difference in the calculation of residual income versus EVA is that RI does not capitalize adjustments to the equity section of the balance sheet and modify income to remove purported GAAP distortions from the calculation [Chen and Dodd (2001)]. Further, EVA makes use of principles and measures of modern financial theory (such as the CAPM)[12] in order to arrive at the weighted average cost of capital (WACC).

EVA = ANOPAT – Cap (WACC) where (4)

ANOPAT = adjusted net operating profit or

EVA = Cap (r -WACC) where (5)

r = realized adjusted return of the project (or firm / division)

RI = unadjusted EVA (6)

According to the formula above, there are five ways to increase EVA. First, EVA increases when the return on existing capital increases. A second way is profitable growth, generated when new investments return more than the WACC of the firm. Third, divestments of activities, whose return is smaller than the WACC required. Fourth, the longer the period where RONA exceeds WACC the more value is created[13] and finally, the lower the cost of capital, the higher EVA will be.

Even when a division generates positive EVAs, value can be created by divestment if the unit is worth more to other firms than the net present value of all future EVAs.

1.3.2 Accounting Adjustments

There are two major distinctions between accounting and economic value added. First, EVA considers a charge for both debt and equity capital cost. Second, it reflects cash-basis accounting, while accounting profits use the accrual method [Peterson and Peterson (1996)]. In order to arrive at EVA, adjustments to accounting profit are necessary (Appendix I on pages 57-58 presents the most common adjustments).

However, as Young and O’Byrne (2001)[14] state, the goal of corporate performance measurement should never be exaggerated accuracy, but rather a cost-effective evaluation and compensation system that aligns managers’ and shareholders’ interests. Consequently, accounting adjustments should be only made when distortions, which arise from GAAP accounting, lead to suboptimal behavior and could be overcome by adjustments [Stewart (1994)]. For a further discussion I refer to Stewart (1991), Dierks and Patel (1997), and Young and O’Byrne (2001).

Even though, Stern and Stewart offer 164 possible accounting adjustments [Stewart (1991)], in practice the number of recommended adjustments have declined over recent years. Many managers are reluctant to diverge significantly from GAAP accounting, the more so as the impact of adjustments is often not significant [Young and O’Byrne (2001).[15]

The following table shows the relation of net income, NOPAT, residual income, and economic value added.

illustration not visible in this excerpt


1.3.3 Early Euphoria

As shown above the concept of residual income and, therefore, economic value added is not new. But how can one explain the euphoria, which started at the beginning of the 1990s? Even tough the label already appeared in Finegan (1989) and Walter (1992), EVA it did not receive much attention before an article in Fortune, which praised the concept as “today's hottest financial idea and getting hotter.” [Tully (1993)]

Since then, various articles in the popular press and practitioner journals reported anecdotal evidence from firms, which successfully implemented EVA as a measure for corporate performance [e.g. Walbert (1993), Rutledge (1993), Walbert (1993 and 1994), Birchard (1994), Brossy and Balkcom (1994), Byrne (1994), Copeland and Meenan, (1994), McConville (1994), White (1994), Bennett (1995), Fisher (1995), Ettorre (1995), Ochsner (1995), Stewart (1995), Birchard (1996), Carr (1996), Gressle (1996), Davies (1996), Gapenski (1996), Martin (1996), Lehn and Makhija (1996), Rice (1996), Ross (1996), Topkis (1996), and Pallerito (1997)].

Zarowin (1995)] predicted that EVA will replace earnings per share (EPS) in The Wall Street Journal’s regular stock and earnings reports, and Credit Suisse First Boston as well as Goldman Sachs included EVA in their analyses of companies [Lowenstein (1997)]. Due to this excitement it is not surprising that companies are increasingly attracted to have a closer look at EVA. Among the first firms, which successfully included the concept, are Coca Cola, AT&T, Chrysler, General Electric, Compaq Computer, and the U.S. Postal Service.

One significant result of this early popularity of EVA was an increasing interest in the underlying concept of economic profit, which reduced the emphasis on accounting profits. Various scholars have shown the benefits from such a shift [Rutledge (1993), Sheenan (1994), Jones (1995), Ochsner (1995), and Saint (1995)]. Of course, the strongest proponents are Stewart (1991) and Stern (1993a, 1993b, 1994). The following section summarizes arguments of EVA proponents, which might be able to explain the increasing popularity associated with the label.

1.3.4 Advantages of EVA

Stewart (1991) criticizes the inconsistency of using different financial measures for different corporate functions.[16] He claims, EVA can serve as a single measure for capital budgeting, goal setting, communication with investors, as well compensation for managers. Stewart (1994) states the purpose of the framework with serving as the centerpiece of an integrated financial management and incentive compensation system and claims it is the ultimate measure for shareholder wealth and executive compensation. EVA is supposed to overcome the preceding problems of other metrics by providing a link between performance measurement and capital market valuation.

EVA advocates argue that equity capital is expensive in a free market economy, where capital has alternative uses; and should be considered to determine the total cost of capital. Therefore, it is claimed that EVA instills capital discipline [Achtstatter (1995)]. Since accounting earnings ignore equity capital, they are regarded as incomplete measures of economic reality.

The recognition of an equity capital charge is not controversial. There are strong arguments for the integration of such a charge from Anthony (1975 and 1982) and Ochnser (1995). Ochsner’s groundbreaking valuation model paved the way for a widely acceptance of the idea. However, it took decades to bring such a model to maturity, since it is based on work by Preinreich (1937); Edey (1957); Edwards and Bell (1961); and Peasnell (1981 and 1982), and is often referred to as the Edwards-Bell-Ohlson Model (EBO).

EVA proponents claim a further advantage: alleged distortions introduced by Generally Accepted Accounting Principles (GAAP) are eliminated through accounting adjustments.[17] Further, it is purported that EVA makes use of principles and measures of modern financial economics to provide a more accurate measure for the WACC.

The main feature of EVA however, as claimed by its advocates, is its ability to serve as a divisional performance measurement. EVA can restore the line of sight at divisional levels because it can be measured at every unit as long as NOPAT, invested capital, and WACC[18] are known.

Stern [Stern, Stewart and Chew (1994)][19] praises EVA’s ability to be used as an interim performance measure, which makes the metric superior to the discounted-cash-flow approach (DCF).[20] Furthermore, Young and O’Byrne (2001) show even a slightly negative correlation between free cash flows and market value since both poorly performing companies and successful, but rapidly growing, firms are likely to have negative FCFs. Stewart adds another argument: since EVA is based on earnings, it is easier to grasp by managers. The simplicity of EVA is also emphasized in Birchard (1994). Also Farcio, Degel, and Degen (2000) take a stand in favor of EVA since it “clearly specifies to management that the primary financial objective of the company is to create shareholder wealth. Secondly, it emphasizes continuous improvement in the company's EVA as the basis for increased shareholder wealth.”

1.3.5 EVA and MM [O’Byrne (1996)]

According to various[21] academics, modern valuation theory began with Miller and Modigliani (1961), who quoted that the value of the firm equals the current plus expected future cash flows from operations (CFO).

O’Byrne tries to prove the validity of the EVA concept by showing its consistency with the Modigliani Miller model of 1961. EVA proponents claim the following relationship to be true:

illustration not visible in this excerpt (7)

The formula indicates that linking management compensation to EVA improvement can reduce conflicts of interests between managers and owners.[22]

MM stated the following equation:

illustration not visible in this excerpt (8)

I = new investment (net of depreciation)

r = realized return

MV = market value of the firm

According to the equation, the value of the firm is broken down into two components: NOPAT0 / WACC represents the firm’s current earnings stream as a perpetuity (going concern). This is also referred to as the firm’s current operations value (COV).

The second component equals the firm’s future growth value (FGV). Only if the firm’s new investment earns a return greater than the cost of capital, the FGV is positive. Thus, the company’s current market value reflects its prospects for profitable growth in the future. Net investment times the spread between WACC and generated return equals EVA improvement in year t+1:

It (rt -WACC) = DEVAt+1 (9)

The implementation of (9) into (8) results in equation (10):

illustration not visible in this excerpt (10)

The market value of a firm is dependent on the capital market expectations of future EVA. EVA advocates indicate two sources for future EVAs: first, a continuation of the current performance into perpetuity and second, EVA improvement. The sum of already invested capital and the perpetuity of current EVAs equal the current operating value (COV). The capitalized value of EVA improvements is the future growth value (FGV). Consequently, in order to increase its share value, a company has to exceed EVA expectations in the current year and (or) create excess FGV. Since excess return is defined as actual wealth minus expected wealth (equation (2) on page 5), the following relation is true (11):

ER = capitalized future value of excess EVA improvement +
excess future growth value

MV = Cap + ER (12)

When NOPAT-1 / WACC and (Capl-1 - Cap-2) are added and subtracted to the right side of the modified MM equation (10) the following formula is the result:


[1] This paper is in accordance with the academic world, which suggests shareholder wealth maximization as the overall goal for the firm since shareholders bear the most risk and are the owners of the firm.

[2] The congruence of the EVA-approach and free cash flow methods is considered in Hartmann (2000) ; and Shrieves and Wachowicz (2001).

[3] The metrics are identical and used interchangeably.

[4] “What remains of his profits after deducting interest on his capital at the current rate may be called his earnings of undertaking or management.” - Marshall (1890)

[5] Invested capital refers to the sum of shareholders’ equity, all interest-bearing debt and other long-
term liabilities [Young and O’Byrne (2001) p. 29]

[6] pp. 28-29

[7] This is the ratio of the market value of assets divided by their replacement costs. He argues that
the combined stock market valuations to the combined replacement costs should be
around one [see Tobin (1969)].

[8] p. 63

[9] p.67

[10] The label Economic Value Added (EVAÔ) was created by G. Bennett Stewart and Joel. M. Stern of Stern Stewart and Company, who also hold the property rights on the symbol. The trademark symbol will not be displayed throughout the rest of the paper.

[11] A New York City based consulting firm

[12] Even though the use of the CAPM as suggested by Sharpe (1964) and Lintner (1965) is highly controversial, so far the academic world did not come up with a superior model. Some academics propose multi-factor models such as the Arbitrage Pricing Theory [Ross (1976)], or the Fama- French three-factor model [Fama and French (1992, 1993, 1995)]. Though these models eliminate some of the restrictions of the CAPM, they raise new concerns.

[13] This period is referred to as the Comparative Advantage Period (CAP).

[14] p. 266

[15] p. 266

[16] The concept of discounted cash flow (DCF) is used for capital budgeting, while goals and investor communication are based on accounting measures.

[17] As shown in a later section, these accounting adjustments are not free of criticism.

[18] However, the calculation of appropriate divisional hurdle rates is not free of obstacles.

[19] p. 64

[20] Both methods, discounted EVA and discounted cash-flow deliver the same results according to Hartman (2000); and Shrieves and Wachowicz (2001). However, future EVAs are not cash flows and cannot be used to prepare cash budgets.

[21] Stephen F. O’Byrne is a very strong proponent of the EVA concept and published several articles aiming at proving the validity of the label. However, as former Vice President of Stern Stewart and Co. his empirical findings are not regarded as independent.

[22] This alignment is subject of the second part of this paper.


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Title: EVA as a measure for shareholder value and executive compensation - A critical view