Evaluating Economic Value Added as a means of establishing corporate performance

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Historically, performance systems were build up as a means of observing and maintaining organizational control, which is the course of ensuring that an organization follow strategies that direct to the success of general goals and objectives (Nanni , et al 1990) [i] .Performance measurements can provide managers with vital informational as it is regarded forward looking scheme of measurements that help in the prediction of companies economic performances and distinguish necessary changes in operations. The reality of today's competitive environment forces business to focus more on improving profitability thus all type of firms are implementing value based measures using measures such as EVA.

A New York Consulting firm, Stern Stewart & Company (SSC) in 1982 developed EVA measure, to support value maximizing behavior in corporate managers. It had the intention to assess business strategies, capital projects and to capitalize on long term shareholders value. An increase in the market value of the company can happen through EVA, contrasting profits with the cost of capital used to produce certain projects can lead to decisions of withdraw and invest in other projects that are vital to shareholder's wealth. EVA is also used by financial analysts to measure firm's performance. The primary success of a firm is measured primarily by whether the firm's actions are creating value for its owners and not by its capacity to expand its sales, produce profits or generate cash from its operations (Ehrbar, 1998).

Stern Steward (1991) described four key purposes of EVA with four words, Measurement most precise measure of corporate performance over any given period , Management system which means it can be used as a foundation for a comprehensive management system ,Motivation based on incentive compensation and lastly, Mindset explained as EVA transforms a corporate culture.

EVA is a measure that makes possible for managers to observe whether they are earning and suitable return on the capital under their control. The basic idea is that a flourishing firm should receive at least its cost of capital.EVA can be express as following:

EVA=Net Operating Profit After Tax (NOPAT) - Cost of Capital

NOPAT is net operating profits after tax, and capital charge is the cost of capital multiplied by the amount of capital.EVA removes existing distortions by using up to 164 adjustments to traditional accounting data(Stewart 1991) .The adjustments to GAAP statements it's what challenges managers and investors. The cost of capital is generally the weighted average cost of capital(WACC) using the risk adjusted return from equity as calculated by the CAPM (Weaver 2001). Therefore, EVA provides a measure of economic profit. A positive EVA means that the after-tax operating income is greater than the cost of the investment to make its income, in other words, the company makes a profit. On the other hand, a negative EVA gives rise to consuming capital instead of creating wealth.

EVA Evaluation

The evidence of EVA'S relationship with corporate performance are mixed, as happens with mostly new techniques, new theories and new processes introduced. A number of researchers argue that the EVA can provide a number of benefits to a firm using it. The book by Bennett Stewart, The Quest of Value (1999), introduces EVA and market value added measures and their expected benefits. As argued by Stewart 1995 the new management tool is being used by companies such as AT&T, Coca-Cola, and Quaker Oats .Coca-Cola saw its stock price increase from $3 in 1981 ,when Coke first adopted EVA to over $60.(Ray 2001). Similarly CSX's stock price soared from $28 to $75 between 1988 and 1993(Tully 1993).

Enron is an example of managers craving to demonstrate better earnings, managers put bad investment for their own benefit because of the culture in the organization. They were driven by a desire to maximize EPS (Earnings per share).The argument made by a number of authors is that if Enron used EVA they would have realized that they were not generating adequate returns as compared to their capital employed (P.Singh 2006). David Phillips (2007) declares that EVA instructs managers to create value only in three certain ways. First of all, by functioning more efficiently without using more capital managers can boost the return of the company's current assets. The second way is to invest in new capital and grow the business given that returns are greater than the cost of capital. Lastly, companies by selling assets that can be better utilize by someone else and freeing up capital, they can see an increase in the value.

In order to discuss the strengths of EVA, Return on Investment (ROI) must be explored first. This measure is exercised to assess the success of a company or division by contrasting its operating income to its invested capital.ROI is employed to control the size of divisions. The main drawback of ROI is that it can support managers, who are evaluated and rewarded based exclusively on this measure to make investment decisions that are in their own best interests,and not in the best interest of the company (Morse et al 1996) [ii] .Brewer (1999) argues that EVA will defeat this problem ,because EVA would motivate the manager to accept any investment choices that generate a return greater than the company's cost of capital. The key difference between ROI and EVA is mainly that with ROI any investment alternative that offers a return less than the cost of capital will not be supported by division managers or the company and vice versa, if the returns are greater, will be seen favorably from managers. With EVA any investment opportunity greater than zero will be viewed favorably from division managers and the company and vice versa investment opportunity less than zero is viewed unfavorably by division managers.EVA it's a measure of wealth creation that aligns the aims of divisional managers with the goals of the whole company (Brewer 1999)

Even though EVA has a number of advantages over ROI, four limitations have been identified. First of all, EVA cannot manage size differences across plants or divisions(Hansen &Mowen 1997) [iii] . A higher EVA will exist in larger plants or divisions in comparison with smaller divisions or plants. Secondly, EVA relies on financial accounting techniques of revenue recognition and expense realization because it's a calculated number. Managers can manipulate the results of EVA by changing their decision making process (Horngren et al 1997) [iv] ..Thirdly, EVA overstates the fact to generate instant result; that's why it produces a disincentive for managers to invest in pioneering products or process technologies. Mangers are enforced to put excessive emphasis on the short-term bottom line. Aggregate financial numbers such as EVA, which are collected at the end of an accounting period don't help identify the causes of operational inefficiencies; consequently EVA limits helpful information to the managers who are responsible for the business processes.

A further benefit of EVA over accounting earnings is that alleged distortions, established by GAAP accounting are eliminated.EVA measures better the wealth that a firm has formed during a period than accounting earnings because it explicitly allocates a cost of equity and removes distortions of accounting conventions. In other words, EVA let investors to assess whether the return earned on invested capital surpass its cost as determined by the return from other capital uses(Chen and Dodd, 1998).A main concern for investors is wealth created , they claim that EVA is the only measure that attached directly to the intrinsic value of a company's stock (Stewart 1999)

The initial literature stating the helpfulness of EVA as a performance measure of a firm and its management at an overall or a divisional level it's the book written by Stewart (1991) The Quest of Value. He revealed a strong correlation between EVA and MVA (Market Value added).The changes in EVA and MVA gave an R of 97%.On the other hand, for a negative EVA the relationship becomes less noticeable. Steward (1994) researched further on EVA, and he elucidated that EVA is the best accounting factor to be used to forecast the change of MVA.MVA as argued, can be explained 50% by EVA, 10% by sales, 15-20% by Earnings per share(EPS) and 35% by the change in Return on Equity(ROE).More than a few other empirical studies offered results arguing in opposition to the advanced informational context of EVA. Dodd and Chen(1996) gave details that EVA can only explain the 24.5% of the corresponding variability.EVA showed that it have higher explanatory power, when it was compared with ROE and EPS but when it was contrasted with a simple measure of residual income they couldn't find any major incremental informational context. EVA is just a retreaded model of residual income and there is no necessity for the large number of "equity adjustments" included in the Stern Stewart system. (Chen & Dodd 1997).

In the same line, Peterson and Peterson (1996)found that EVA has a low correlation with stock returns , whereas the measures based solely on MVA are statistically significantly correlated with stock returns.

Turvey et al (2000) published an article examining the relationship between EVA and stock performance of Canadian food processing and other authors in other industries (Balicore, Boquist,Milbourn&Takor et al,1997;Biddle,Brown &Wallace, 1997;) and no relationship could be found that EVA offered no advantage over other accounting based measures. The same result has been found in different markets. Biddle et al (1997) used a sample from a data set from Stern Stewart and again established that the relationship between earnings per share and 12 month compounded annual return was stronger than between Eva and return .Similarly, deViliers and Auret(1997) find that EVA is less useful that other measures, specifically EPS(Earnings per share) I, there are no evidence of benefits using EVA instead of EPS in share price analysis. Kyriazis and Anastassis(2007) investigated the power of EVA in comparison with other traditional accounting performance measurement (net income, operating income) based on the Greek Stock exchange using the dataset ASE(Athens Stock Exchange).Stern Stewards claims that EVA is more correlated with the stock market returns are not supported by the two authors. Actually, examining the relationship between firms MVA and EVA, they found that EVA does not perform significantly better than the other variables, failing to support Stern Stewart's fundamental say.

O'Byrne (1996) identified that EVA, not like NOPAT or other earnings measures, is thoroughly associated to the market value and that EVA is a strong efficient tool for understanding the investors' prospects that are integrated into a company's current share price. Also, a regression analysis conducted by Uyemura et al of 100 largest US banks from 1986 to 1995 provided proof of EVA's correlation with shareholder wealth creation.It's being argued in an article written by Farsio et al (2000) That EVA indicates to managers that the main financial goal of the company is to create shareholder wealth, as it promotes shareholders interests. Also, it highlights ongoing improvement in the company's EVA as the basis for increased shareholder wealth. Stock prices reflects the company's performance, consequently the level of EVA isn't significant although changes in the level are, if we assume the efficient market hypothesis holds. If management focuses on these issues the EVA can increase. An increasing EVA has been suggested to causing stock prices to rise, consequently pleasing shareholders interest. AT&T's CFO claims that his company's EVA and stock prices have had an almost perfect correlation since 1985(Fortune 1993) [v] .Farsio et al(2000) also tried to verify the relationship between EVA and stock return .They carried out an empirical study , from data from companies using EVA.The results showed that it only explained a fraction of the variability in stock return fluctuations, and they stated that other measures are superior to EVA in explaining this variability. They showed that EVA is not a good indicator of stock performance.

A main drawback is its over-reliance on historical, financial measures for example, profit margin, asset turnover, cost of money and level of capital invested in a company. Research conducted in last couple of years showed that financial oriented measured are not suggestive of future performance .In a number of industries and business sectors leading drivers (i.e forward looking ) have shown more significant in predicting future EVA than current EVA, except they are not directly integrated in most EVA system. These drivers are often non -financial in nature and include such factors such as product innovation, customer satisfaction, loyalty, employee productivity, product quality and brand equity. The importance of these drivers is because they focus on the activities of frontline employees on value creation and drive management to develop strategies with must greater precision. The vital issue is how to integrate this financial and non financial drivers in the planning and evaluation procedures.(H.Fletcher 2004)

EVA has several weaknesses. Specifically there are three inconsistencies in the calculation of CAPITAL, and more inconsistencies in the calculation of NOPAT.(Keys et al 2001) Steward stated that CAPITAL is "....the sum of all cash that has been invested in a company's net assets over its life and without regard to financing form, accounting name, or business purpose-much as if the company were a saving account (Steward, 1991, p.86).There are irregularity in the application of this definition .

First of all, EVA computation does not contain non-interest-bearing current liabilities, for instance, accounts payable in capital. On the other hand, as long as the company maintains or expands its business, non -interest bearing current liabilities would never be pay back. Non-interest bearing current liabilities should be taken into consideration and imputed interest net of taxes on these liabilities should be put in back to NOPAT. Secondly, EVA is inconsistent when all capital items are valued on the same basis. Thirdly, the cumulative goodwill amortization is added back to capital in order to re-establish the first investment of cash in goodwill. But, the same process it's not applied to the accumulated depreciation to re-establish the first investment of cash in fixed assets. According to Steward "NOPAT" "is the profits derived from the company's operation after taxes but before financial costs and non-cash bookkeeping entries. As such, NOPAT also is the total pool of profits available to provide a cash return to all financial providers of capital to the firm" (Stewart ,1991, p.86).In this definition there are a number of discrepancies. Stewart argues that goodwill amortization should be added back to the earnings to calculate NOPAT because it's a non-cash charge .Nevertheless Stewart argues that depreciation should not be added back because "it is a true economic expense" (Stewart 1991, p. 86), but depreciation is also a noncash charge. He is unsuccessful to defining what a "true" economic expense is. Steward also, suggested that R&D expenses should be amortized against earnings over the expected payoff period for the winning projects after been capitalized. In this case, Stewart uses the accrual basis approach rather than the cash basis. This one contradicts with former adjustments used to calculate EVA, which alter accrual net income to a sum close to cash from operations.

Keys et al (2001) identified a number of general limitations of EVA . EVA will rise as the debt-to-equity increases, due to the fact that the attributed cost of common equity will be higher than the cost of borrowing which results o disproportional borrowing. The effect of this is a highly leveraged capital structure. In order to prevent this problem, Stewart suggestion is the usage of the WACC of the desired capital structure instead of the actual in EVA calculation. Nevertheless, the guidelines of the verification of the targeted capital structure are not provided. Additionally, the utilization of a higher cost of capital will cause projects with higher potential returns, consequently riskier investments, to be accepted, while projects having reasonable potential returns and risks will be rejected. Any of these actions can be contradictory with the company's objectives.


Solely relying on EVA for the assessment of managers performance, which are held responsible for end results it's consider a mistake. Instead they should be accompanied by a balance variety of measures to encompass all the performance features crucial for long term achievement. A framework called the "balance scorecard" have been developed by Kaplan and Norton (1992),which defines four precise types of performance attributes which are vital to long-term success. It includes the customer perspective, internal business process, the innovation, learning and financial perspective. According to Chen& Dodd(1997) even though EVA offers vital information value, other accounting profit measures also offer vital information and should not be dismissed in support of EVA only.