EVA AND ITS CRITICS

This paper responds to the article by Biddle, Bowen, and Wallace (BBW) by suggesting that their study of EVA and earnings has three potential shortcomings:

• (1)

   A closer look at BBW's regression analysis suggests that investors, while apparently ignoring the cost of equity, put great weight on the cost of debt —a puzzling result in need of an explanation.
• (2)

   The attempt by BBW to "level the playing field" effectively makes the NOPAT model into a NOPAT and capital model. Thus, it is really an EVA model in disguise and offers no insight into the explanatory power of NOPAT or earnings by itself.
• (3)

   BBW's model of expectations is too simple. The ability of EVA to explain shareholder returns depends upon the accuracy of the model of expected EVA performance, and BBW make no attempt to derive a model of expected EVA improvement from the EVA valuation equation.

     

Beyond accounting and back: An empirical examination of the relative relevance of earnings and “other” information

Ohlson (1995) models firm value as a function of book value, earnings, and analysts' earnings forecasts which capture “other” information not yet reflected in the financial statements. Within this framework, stock returns reflect information from earnings and forecasts, each of which is different in terms of reliability and timeliness. For the period 1984–2012, this paper examines time trends and the influence of aggregate market conditions on the relative relevance of earnings and forecasts. In this context, relative relevance is defined as the incremental explanatory power of earnings or forecasts, relative to their combined explanatory power with respect to the cross-section of stock returns. This inquiry is motivated by anecdotal evidence and recent research, which suggests that aggregate market conditions influence the usefulness of accounting information for investors. The findings show that while the relative relevance of earnings has remained stable, the relative relevance of forecasts has increased over time. I also find that the relative relevance of earnings is higher in bad years, i.e. years with low market returns or elevated market uncertainty. Overall, the results reported in this study suggest that despite the increase in the relevance of timely “other” information, investors tend to rely more on reliable accounting information during bad years.     

EVIDENCE ON EVA

EVA has attracted considerable attention as an alternative to traditional accounting earnings for use in both valuation and incentive compensation. With a host of consultants now marketing related metrics, numerous claims have been made—most based on anecdotal evidence or in-house studies. This paper summarizes the authors' independent evidence regarding EVA's alleged advantages.
The authors begin by reviewing the theory that links the underlying concept of residual income to shareholder value. Second, they discuss how Stern Stewart modifies residual income to produce its proprietary EVA metric and show how median EVA compares with residual income, net income, and operating cash flows over the period 1988–97. Third, they examine the claim that EVA is more closely associated with stock returns and firm value than is net income. Their evidence indicates that EVA does not dominate net income in associations with stock returns and firm values. Fourth, they examine a second claim that compensation plans based on residual income motivate managers to take actions consistent with increasing shareholder value. Here the evidence (from a study by Wallace) suggests that managers do respond to residual income-based incentives by, for example, increasing asset sales, cutting capital expenditures, repurchasing stock, and producing higher levels of residual income. The authors conclude by arguing that a metric such as EVA can be effective for internal incentive purposes even if it conveys little news to market participants regarding the firm's valuation.     

Financial Management Association Roundtable on Stock Market Pricing and Value‐Based Management

A group of academics and practitioners addresses a number of questions about the workings of the stock market and its implications for corporate decision‐making. The discussion begins by asking what the market wants from companies: Is it mainly just steady increases in earnings per share, which are then “capitalized” by the market at the current industry P/E multiple to produce a higher stock price? Or does the market pay attention to the “quality,” or sustainability, of earnings? And are there more revealing measures of annual corporate performance than GAAP earnings—measures that would provide investors with a better sense of companies' future cash‐generating capacity and returns on capital? The consensus was that although many investors respond uncritically to earnings numbers, the most sophisticated and influential investors consider far more than current earnings when pricing stocks. And although the stock market is far from omniscient, the heightened scrutiny of companies resulting from the growth of hedge funds, private equity, and investor activism of all kinds appears to be making the market “more efficient” in building information into stock prices. The second part of the discussion explored the implications of this view of the market pricing process for corporate strategy and the evaluation of major investment opportunities. For example, do acquisitions have to be “EPS‐accretive” to be value‐adding, or is there a more reliable means of assessing an investment's value added than pro forma EPS effects? Does the DCF valuation method always offer a better guide to value than the method of comparables used by many Wall Street dealmakers? And under what circumstances are the relatively new real options valuation approaches likely to provide a significant advantage over conventional methods? The main message offered to corporate practitioners is to avoid letting cosmetic accounting effects get in the way of value‐adding investment and operating decisions. As the corporate record on acquisitions makes painfully clear, there is no guarantee that an accretive deal will turn out to be value‐increasing (in fact, the odds are that it will not). As for choosing a valuation method, there appears to be a time and place for each of the major methods—comparables, DCF, and real options—and the key to success is understanding which method is best suited to the circumstances.     

Momentum and Foreign Investors: Evidence from the Korean Stock Market

Abstract:

We examine whether the price impact of foreign investors on the Korean stock market from December 2000 to February 2007 generated a momentum phenomenon. In our empirical results, foreigners seem to have exerted a significantly positive impact on prices in “up” markets (periods of positive stock returns), but have had little impact on prices in “down” markets (periods of negative returns). We document that the impact of foreigners’ trades is concentrated in large companies. Most importantly, when the market is in the up state, the returns of stocks of large companies that were positively affected by foreign investors in the previous six-month period continue to increase in the subsequent six-month period. As a result, the subsequent six-month return on a past “winner” stock portfolio is significantly higher than that on a past “loser” stock portfolio. This brings to mind a momentum phenomenon that has been reported not to exist in the Korean stock market.     

Expectations‐Based Management

The authors begin by summarizing the results of their recently published study of the relation between stock returns and changes in several annual performance measures, including not only growth in earnings and EVA, but changes during the year in analysts' expectations about future earnings over three different periods: (1) the current year; (2) the following year; and (3) the three‐year period thereafter. The last of these measures—changes in analysts' expectations about three‐ to five‐year earnings—had by far the greatest explanatory “power” of any of the measures tested. Besides being consistent with the stock market's taking a long‐term, DCF approach to the valuation of companies, the authors' finding that investors seem to care most about earnings three to five years down the road has a number of important implications for financial management: First, a business unit doesn't necessarily create shareholder value if its return on capital exceeds the weighted average cost of capital—nor does an operation that fails to earn its WACC necessarily reduce value. To create value, the business's return must exceed what investors are expecting. Second, without forecasting returns on capital, management should attempt to give investors a clear sense of the firm's internal benchmarks, both for existing businesses and new investment. Third, management incentive plans should be based on stock ownership rather than stock options. Precisely because stock prices reflect expectations, the potential for prices to get ahead of realities gives options‐laden managers a strong temptation to manipulate earnings and manage for the short term.     

A Better Way to Measure Operating Performance (or Why the EVA Math Really Matters)

Most companies rely heavily on earnings to measure operating performance, but earnings growth has at least two important weaknesses as a proxy for investor wealth. Current earnings can come at the expense of future earnings through, for example, short‐sighted cutbacks in investment, including spending on R&D. But growth in EPS can also be achieved by investing more capital with projected rates of return that, although well below the cost of capital, are higher than the after‐tax cost of debt. Stock compensation has been the conventional solution to the first problem because it's a discounted cash flow value that is assumed to discourage actions that sacrifice future earnings. Economic profit—in its most popular manifestation, EVA—has been the conventional solution to the second problem with earnings because it includes a capital charge that penalizes low‐return investment. But neither of these conventional solutions appears to work very well in practice. Stock compensation isn't tied to business unit performance—and often fails to provide the intended incentives for the (many) corporate managers who believe that meeting current consensus earnings is more important than investing to maintain future earnings. EVA doesn't work well when new investments take time to become profitable because the higher capital charge comes before the related income. In this article, the author presents two new operating performance measures that are likely to work better than either earnings or EVA because they reflect the value that can be lost either through corporate underinvestment or overinvestment designed to increase current earnings. Both of these new measures are based on the math that ties EVA to discounted cash flow value, particularly its division of current corporate market values into two components: “current operations value” and “future growth value.” The key to the effectiveness of the new measures in explaining changes in company stock prices and market values is a statistical model of changes in future growth value that captures the expected effects of significant increases in current investment in R&D and advertising on future profits and value.     

Does the media help or hurt retail investors during the IPO quiet period?

We examine how the media influences retail trade and market returns during the “quiet period” that follows a firm's IPO. We find that more media coverage during this period is associated with more purchases by retail investors and that such purchases are attention-driven, rather than information-based. Further, these retail trades are negatively associated with stock returns at the firm's first earnings announcement post-IPO. Our results suggest that media coverage, combined with market frictions that limit price efficiency in the post-IPO period, leads to worse investing outcomes for retail investors.     

Drivers of Shareholder Returns in Tech Industries (or How to Make Sense of Amazon's Market Value)

Earnings according to GAAP do a notoriously poor job of explaining the current values of the most successful high‐tech companies, which in recent years have experienced remarkable growth in revenues and market capitalizations. But if GAAP earnings fail to account for the values of such companies, are there other measures that do better? The authors address this question in two main ways. They begin by summarizing the findings of their recent study of both the operating and the stock‐market performance of 169 publicly traded tech companies (with market caps of at least $1 billion). The aim of the study was to identify which of the many indicators of corporate operating performance—including growth in revenues, EBITDA margins, and returns on equity—have had the strongest correlation with shareholder returns over a relatively long period of time. The study's main conclusion is that investors appear to be looking for signs of neither growth nor efficiency in using capital alone, but for an optimal mix or balancing of those goals. And that mix, as the study also suggests, is captured in a cash‐flow‐based variant of “residual income” the authors call “residual cash earnings,” or RCE. In the second part of their article, the authors show how and why RCE does a much better job than reported net income or EPS of explaining the current market value of Amazon.com , one of the best‐performing tech companies in the world. Mainly by treating R&D spending as an investment of capital rather than an expense, RCE reveals the value of a company that is distinguished by both the amount and the productivity of its ongoing investment—both of which have been obscured by GAAP.     

EVA AND THE "NEW ECONOMY"

Some have observed that the new economy means the end of the EVA performance measurement and incentive compensation system. They claim that although the EVA system is useful for oldline companies with heavy investments in fixed assets, the efficient management of investor capital is no longer an imperative for newage firms that operate largely without buildings and machinery–and, in some cases, with negative working capital. This article argues that EVA is not only suitable for the emerging companies that lead the new economy, but even more important for such firms than for their “rust belt” predecessors. While there may be a new economy in terms of trade in new products and services, there is no new economics– the principles of economic valuation remain the same. As in the past, companies will create value in the future only insofar as they promise to produce returns on investor capital that exceed the cost of capital. It has made for sensational journalism to speak of companies with high valuations and no earnings, but this is in large part the result of an accounting framework that is systematically flawed. New economy companies spend much of their capital on R&D, marketing, and advertising. By treating these outlays as expenses against current profits, GAAP accounting presents a grossly distorted picture of both current and future profitability. By contrast, an EVA system capitalizes such investments and amortizes them over their expected useful life. For new economy companies, the effect of such adjustments on profitability can be significant. For example, in applying EVA accounting to Real Networks, Inc., the author shows that although the company reported increasing losses in recent years, its EVA has been steadily rising–a pattern of profitability that corresponds much more directly to the change in the company's market value over the same period. Thus, for stock analysts that follow new economy companies, the use of EVA will get you closer to current market values than GAAP accounting. And for companies intent on ensuring the right level of investment in intangibles– neither too much nor too little– EVA is likely to send the right message to managers and employees. The recent decline in the Nasdaq suggests that stock market investors are starting to look for the kind of capital efficiency encouraged by an EVA system.     

Value relevance of international accounting standards harmonization: Evidence from A- and B-share markets in China

Applying both the price-levels model and the lagged-price-deflated returns model, we investigated the incremental value relevance of the reconciliation of accounts from the Chinese Accounting Standards (CAS) to the International Accounting Standards (IAS) by those Chinese listed companies that have simultaneously issued A-shares and B-shares. In addition, we examined the usefulness of accounting numbers (earnings and book values) and their value relevance to the A- and B-share markets in China. The study finds that earnings and book values of owners’ equity determined under CAS are more relevant accounting information for the purpose of determining the prices of A- and B-shares. The CAS-based earnings changes were reflected in stock returns in the B-share market, while the CAS-based earnings were closely associated with stock returns in the A-share market. However, the study found that the reconciliation of earnings and book values from CAS to IAS basis is partially value-relevant, mainly to stock prices in the B-share market, while the earnings reconciliation is generally not value-added to stock returns in either the A- or the B-share market. The study results suggest that accounting numbers based on domestic accounting standards, in contrast to IAS, are more value-relevant in the Chinese stock market at present.     

Does the Stock Market Overreact to Corporate Earnings Information?

This paper tests whether the stock market overreacts to extreme earnings, by examining firms' stock returns over the 36 months subsequent to extreme earnings years. While the poorest earners do outperform the best earners, the poorest earners are also significantly smaller than the best earners. When poor earners are matched with good earners of equal size, there is little evidence of differential performance. This suggests that size, and not investor overreaction to earnings, is responsible for the “overreaction” phenomenon, the tendency for prior period losers to outperform prior period winners in the subsequent period.     

EVA, ACCOUNTING PROFITS, AND CEO TURNOVER: AN EMPIRICAL EXAMINATION, 1985–1994

A growing number of companies use EVA or related measures of economic profits as metrics for corporate planning and executive compensation. Unlike traditional accounting measures of performance, EVA attempts to measure the value that firms create or destroy by subtracting a capital charge from the cash returns they generate on invested capital. For this reason, EVA is seen by its proponents as providing the most reliable year-to-year indicator of a market based performance measure known as market value added, or MVA. Although EVA and MVA have received considerable attention in recent years, there has been little empirical study of these performance measures—and what studies have been produced have provided mixed results. This study joins the debate over EVA vs. conventional accounting measures by asking a different question: Which performance measures do the best job of explaining not only stock returns, but the probability that a CEO will be dismissed for poor performance? Using a sample of 452 firms during the period 1985–1994, the authors report that EVA has a somewhat stronger correlation with stock price performance than conventional accounting measures such as ROE and ROA. But, of greater import, EVA appears to be a considerably more reliable indicator of CEO turnover than conventional accounting measures.     

Why EVA Bonus Plans Failed—and How to Revive Them

Most companies rely heavily on earnings to measure their financial performance, but earnings growth has at least two important weaknesses as a proxy for investor wealth. Current earnings growth may come at the expense of future earnings through, say, shortsighted cutbacks in corporate investment, including R&D or advertising. But growth in earnings per share can also be achieved by “overinvesting”—that is, committing ever more capital to projects with expected rates of return that, although well below the cost of capital, exceed the after‐tax cost of debt. Stock compensation has been the conventional solution to the first problem because it's a discounted cash flow value that is assumed to discourage actions that sacrifice future earnings. Economic profit—in its most popular manifestation, EVA—has been the conventional solution to the second problem because it includes a capital charge that penalizes low‐return investment. But neither of these conventional solutions appears to work very well in practice. Stock compensation isn't tied to business unit performance, and often fails to motivate corporate managers who believe that meeting consensus earnings is more important than investing to maintain future earnings. EVA often doesn't work well because increases in current EVA often come with reduced expectations of future EVA improvement—and reductions in current EVA are often accompanied by increases in future growth values. Since EVA bonus plans reward current EVA increases without taking account of changes in expected future growth values, they have the potential to encourage margin improvement that comes at the expense of business growth and discourage positive‐NPV investments that, because of longer‐run payoffs, reduce current EVA. In this article, the author demonstrates the possibility of overcoming such short‐termism by developing an operating model of changes in future growth value that can be used to calibrate “dynamic” EVA improvement targets that more closely align EVA bonus plan payouts with investors’ excess returns. With the use of “dynamic” targets, margin improvements that come at the expense of business growth can be discouraged by raising EVA performance targets, while growth investments can be encouraged by the use of lower EVA targets.     

Conservatism and Cross-Sectional Variation in the Post–Earnings Announcement Drift

Accounting conservatism allows me to identify a previously undocumented source of predictable cross‐sectional variation in Standardized Unexpected Earnings' autocorrelations viz. the sign of the most recent earnings realization and present evidence that the market ignores this variation (“loss effect”). It is possible to earn returns higher than from the Bernard and Thomas (1990) strategy by incorporating this feature. Additionally, the paper shows that the “loss effect” is different from the “cross quarter” effect shown by Rangan and Sloan (1998) and it is possible to combine the two effects to earn returns higher than either strategy alone. Thus, the paper corroborates the Bernard and Thomas finding that stock prices fail to reflect the extent to which quarterly earnings series differ from a seasonal random walk and extends it by showing that the market systematically underestimates time‐series properties resulting from accounting conservatism.     

EVA IN THE E&P INDUSTRY: THE CASE OF NUEVO ENERGY

This article presents a case study illustrating some aspects of the new business model discussed in the roundtable above. Continuing a major theme in the roundtable, the authors begin by arguing that the long‐run failure of the E&P industry to create shareholder wealth stems to a large degree from weak or distorted incentives held out to the top executives and managers of most large, publicly traded companies. This article traces the incentive problem to the lack of an effective wealth creation metric to guide the financial management process. Although the industry employs a variety of accounting‐based performance measures, none is a reliable measure of wealth creation. In place of traditional financial metrics such as earnings, annual cash flow, and return on capital, this article recommends a performance evaluation and incentive compensation system that is tied to the use of a “reserve‐adjusted” EVA measure—one that exhibits a strong statistical correlation with changes in shareholder wealth in the E&P business. The greater explanatory power of this new measure reflects the reality that changes in the value of reserves in the ground can greatly outweigh changes in annual earnings or cash flows. As the focal point of a compensation plan, EVA has advantages over stock options in that it can be calculated at various levels in the organization, even at the level of a single well, whereas stock prices only exist for the company as a whole. For this reason, an EVA incentive system permits a clearer “line of sight” between pay packages and the performance of the part of the business for which managers are directly accountable. Perhaps even more important, EVA can be calculated (using an “internal hedging” mechanism) in a way that removes the impact of changes in oil prices on the incentive outcome. And, as demonstrated in the case study of Nuevo Energy, such internal hedging allows companies to give their employees a much greater share of wealth created with far less cost than by simply granting stock or stock options.     

When ESG talks: ESG tone of 10-K reports and its significance to stock markets

Since the ESG topic consistently gains on importance in the investment universe, companies provide investors with information regarding recent and future ESG activities through different reporting channels. The most recent research finds relevance of ESG-related corporate activities for formation of investors' opinion regarding companies' valuations and growth prospects. Based on a sample of more than seventeen thousand unique 10-K reports of US companies filed with SEC in period 2013 to 2019 and the word-power methodology proposed by Jegadeesh and Wu (2013), this study also shows evidence for significant relation of ESG textual tone of 10-K reports to stock market returns of filing companies around the report filing dates. Using the ESG linguistic dictionary recently proposed by Baier, Berninger, and Kiesel (2020), this study shows evidence for significant relation of social and governance-related topics disclosure to stock returns, while environmental narratives being ignored by the markets. When looking at individual words from the ESG lexicon, such words as “community”, “health”, “control” imply positive reaction of markets, while “discrimination”, “embezzlement”, and “crime” are related to negative returns. The robustness analysis based on the inverse document frequency word weightings and actual ESG performance scores confirms the significance of ESG information disclosure of 10-K reports for investors. Thus, this study sheds light on the mechanics of ESG information perception and its influence on capital markets.     

From Stock Selection to Portfolio Alpha Generation: The Role of Fundamental Analysis

In this roundtable sponsored by Columbia Business School's Center for Excellence in Accounting Research and Security Analysis, a group of successful investors discuss their approaches and methods. A common saying among financial economists is that stock prices are set not by the average investor, but “at the margin” by the most sophisticated and influential investors. The intent of this roundtable is to furnish a portrait of such “marginal” investors, one that turns out to be quite different from the quarterly earnings‐driven, momentum traders often depicted by the media and deplored by corporate executives. In response to the common charge of short termism leveled by corporate managers, most of the investors at the table claimed to take large, multi‐year positions in companies they believed to be well‐managed, but temporarily undervalued. Instead of being attracted to earnings momentum, and rather than simply capitalizing current earnings at industry‐wide multiples to arrive at price targets, the analysis of these investors begins with a “deep dive” into a company's financials, which is often reinforced by primary research—visits with management, customers, suppliers. The aim of such research is to identify, well before the broad market does, companies that promise to earn consistently high and sustainable returns on invested capital.     

Relative performance evaluation in board cash compensation: UK empirical evidence

This paper presents an empirical examination of whether evidence of the implicit use of relative performance evaluation (RPE) can be found in the cash compensation of boards of directors for 169 UK non-financial listed companies that existed for all of the period from 1971 to 1998. We perform two types of analyses. Initially, we estimate individual firm time series regressions of the change in board cash compensation against measures of firm and peer group performance. The measures of firm performance we use are annual cash stock market returns and pre-tax accounting earnings. Peer group measures of performance are industry value-weighted average cash stock market returns and industry value-weighted average pre-tax accounting earnings. Subsequently, we analyse the data as a balanced panel.We provide evidence that board cash compensation is positively related to accounting earnings and negatively associated with peer group pre-tax accounting earnings. Some evidence suggests that board cash compensation is related to firm stock market returns but none suggests it is related to peer group market returns. This result implies the presence of RPE based on accounting earnings in the design of UK board compensation, with the cash compensation of boards of directors implicitly (partially) protected from industry uncertainties.     

The Early Returns to International Hedge Fund Activism: 2000–2010

In this summary of their recent article in the Review of Financial Studies, the authors provide an overview of the methods and findings of the first comprehensive study of worldwide hedge fund activism—one that examined the effectiveness of some 1,740 separate “engagements” of public companies by 330 different hedge funds operating in 23 countries in Asia, Europe, and North America during the period 2000‐2010. The study reports, first of all, that the incidence of shareholder activism is greatest in companies and countries with high institutional ownership, particularly U.S. institutions. In virtually all countries, with the possible exception of Japan, large holdings by institutional investors increased the probability that companies would be targeted by activists. Nevertheless, in all countries (except for the United States), foreign institutions—especially U.S. funds investing in non‐U.S. companies—have played a more important role than domestic institutional investors in supporting activism. The authors also report that those engagements that succeeded in producing “outcomes” were accompanied by positive and significant abnormal stock returns, not only upon the announcement of the activist's block purchase, but throughout the entire holding period. “Outcomes” were identified as taking one of four forms: (1) increases in dividends or stock buybacks; (2) replacement of board members; (3) corporate restructurings such as sales or spinoffs of businesses; and (4) takeover (or sale) of the entire company. But if such outcomes were associated with high shareholder returns, in the many cases where there were no such outcomes, the eventual, holding‐period returns to shareholders, even after taking account of the initially positive market reaction to news of the engagement, were indistinguishable from zero. The authors found that activists succeeded in achieving at least one of their proposed outcomes in roughly one out of two (53%) of the 1,740 engagements. But this success rate varied considerably across countries, ranging from a high of 61% for North American companies, to 50% for European companies, but only 18% engagements of Asian companies—with Japan, again, a country of high disclosure returns but unfulfilled expectations and disappointing outcomes. Outcomes also tended to be strongly associated with the roughly 25% of the total engagements that involved two or more activists (referred to as “wolfpacks”) and produced very high returns.