HOW TO USE EVA IN THE OIL AND GAS INDUSTRY

The use of EVA in the oil industry has lagged behind that in most other industries because the accounting information reported by oil and gas concerns does such a poor job of representing management's effectiveness in adding value for shareholders. The essence of the problem is that the exploration activities of oil companies create assets whose changes in value are recognized by the stock market long before they are reflected on income statements or balance sheets. As a result, all accountingbased performance measures, including generic measures of EVA (which are derived from accounting information), fail to provide meaningful goals, decision tools, or compensation benchmarks.
This article provides a new, EVAbased framework for performance measurement and incentive compensation for oil and gas firms—and for companies in extractive industries in general. The authors show that, when adjusted by a publicly available measure of hydrocarbon reserve value known as "SEC-10," EVA's ability to explain annual stock returns rises from under 10% to almost 50%. Moreover, because SEC-10 has several important limitations as a measure of reserve value, there is considerable additional room for improving EVA's explanatory power. And the actual implementation of an EVA financial management system for an individual oil company can and should be based on more precise estimates of reserve value than those provided by SEC-10.
To this end, the authors provide an approach to hydrocarbon reserve valuation that captures the "real option" value of undeveloped reserves. By incorporating real option values, this new EVA financial management system for oil companies aligns management's incentives with the goal of creating shareholder wealth by rewarding managers for creating real option value as well as current cash flow—and by forcing managers to consider the optimal "exercise" of such strategic options.     

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.     

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.     

EVA AND DIVISIONAL PERFORMANCE MEASUREMENT: CAPTURING SYNERGIES AND OTHER ISSUES

This article makes three basic points about divisional performance measurement that managers should keep in mind when attempting to choose between EVA and more conventional, accounting-based measures. First, no divisional performance measure, whether it be EVA, divisional net income, or ROA, is capable of capturing synergies among divisions—those shared benefits or costs that make the sum of the parts worth more than the whole. And EVA is neither more nor less effective than more conventional financial measures in deterring divisional managers from taking actions that increase divisional profits at the expense of corporate value. Thus, there is a fundamental contradiction in the very attempt to evaluate the divisions of a multi—divisional firm as if they were independent companies. If there are synergies, divisional performance measures—even those employing transfer prices—are likely to prove inadequate in some respects (and this article recommends some methods for encouraging synergies that might be used to supplement if not replace divisional measures). But if there are no synergies, then top managers should re-examine their business strategy and consider selling or spinning off divisions. Second, a given performance measure's degree of correlation with stock returns should not be management's sole, or even its most important, criterion in choosing to adopt a given performance measure. A better method for evaluating performance measures is to weigh the behavioral or incentive benefits of a given measure against all direct and indirect costs associated with its implementation. In making such a costbenefit analysis, the incentive benefits from the tighter linkage of rewards to share prices provided by more market-based measures should be traded off against the greater market risk and exposure to other uncontrollables imposed by such measures as well as the costs involved in changing the firm's internal accounting and reporting systems. Third, the EVA practice of “decoupling” performance measures from GAAP accounting, while having have potentially significant incentive benefits, also has potential costs in the form of increased auditing requirements and the possibility of litigation.     

An Analysis of the Relation between the Stewardship and Valuation Roles of Earnings

In this paper, we seek a deeper understanding of how accounting information is used for valuation and incentive contracting purposes. We explore linkages between weights on earnings in compensation contracts and in stock price formation. A distinction between the valuation and incentive contracting roles of earnings in Paul [1992] produces the null hypothesis that valuation earnings coefficients (VECs) and compensation earnings coefficients (CECs) are unrelated. Our empirical analyses of the relations between earnings and both stock prices and executive compensation data at the firm and industry levels over the period 1971–2000 rejects Paul's [1992] hypothesis of no relation. We also document an increasing weight over time on other public performance information captured by stock returns in the determination of cash compensation. Specifically, we find that the incentive coefficient on returns is significantly higher in the second of two equal sample subperiods relative to the incentive coefficient on earnings.     

Letting Go of Norm: How Executive Compensation Can Do Better Than "Best Practices"

With executive pay under the media spotlight, the corporate search for “best practices” is in reality a drive toward common practices as cautious boards gravitate toward a safe norm. But are current trends in compensation structure as good for shareholders as they are for the consultants who implement them? This article explores some of these trends and derives some conclusions about their role in shareholder value creation based on detailed data on executive plans and stock price performance for the S&P 500. One key finding is that rewarding managers for profit growth produces higher stock price returns than rewards based on multiple measures or balanced scorecards. Also, the popular practice of adding long‐term incentive plans to the compensation mix does not appear to improve long‐term performance. Finally, the granting of equity based on the past year's performance rather than in annual fixed‐value amounts appears to be good for shareholders because of additional incentives created by performance‐based grants as well as the elimination of the perverse incentive of rewarding poor stock price performance with more shares.     

Incentive effects of executive compensation and the valuation of firm assets

This paper examines how executive compensation influences the market value of the firm's assets. After controlling for endogeneity, we find that boards have set the incentive to incur risk (vega) to maximize shareholder value, but that incentives to increase returns (delta) do not maximize shareholder value. We also find that current levels of cash compensation do not maximize shareholder value. Finally, we consider the moneyness of stock options. We find that the level of at- and out-of-the money options maximize shareholder value, but the level of in-the money options do not maximize shareholder value.     

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.     

An empirical examination of the costs and benefits of executive stock options: Evidence from Japan

In May 1997, the Japanese Commercial Code was amended to allow firms to begin granting stock options as compensation to top management and employees. Nearly 350 firms adopted option-based compensation plans between 1997 and 2001. These options typically have five-year lives and are out-of-the-money by about 5% at the grant date. Firms exhibit abnormal stock returns of about 2% around the announcements of plan adoptions. We find improvements in operating performance and observe that dividend policy and volatility remain unchanged post-adoption. Our evidence suggests that well-designed incentive compensation plans are consistent with the creation of shareholder value.     

Economic Value Added,Future Accounting Earnings,and Financial Analysts' Earnings Per Share Forecasts

Empirical research to date on the relative effectiveness of Economic Value Added (EVA) and earnings per share (EPS) as measures of firm performance for stock valuation has been mixed. In contrast to prior research, which primarily focuses on the correspondence of these measures with shareholder value and changes therein, we examine their relative effectiveness in predicting future earnings and their role in enhancing the accuracy of analysts' forecasts. Our results indicate that EVA contains information that is incremental to EPS in predicting future earnings. In addition, we find that despite this potential for EVA to add incremental value to analysts' forecasts of future earnings, analysts do not use the information in reported EVA appropriately, but appear rather to overweigh it.     

EVA AND TOTAL QUALITY MANAGEMENT

Both TQM and EVA can be viewed as organizational innovations designed to reduce “agency costs”—that is, reductions in firm value that stem from conflicts of interest between various corporate constituencies. This article views TQM programs as corporate investments designed to increase value by reducing potential conflicts among non-investor stakeholders such as managers, employees, customers, and suppliers. EVA, by contrast, focuses on reducing conflicts between managers and shareholders by aligning the incentives of the two groups. Besides encouraging managers to make the most efficient possible use of investor capital, EVA reinforces the goal of shareholder value maximization in two other ways: (1) by eliminating the incentive for corporate overinvestment provided by more conventional accounting measures such as EPS and earnings growth; and (2) by reducing the incentive for corporate underinvestment provided by ROE and other rate-of-return measures. At a superficial level, EVA and TQM seem to be in direct conflict with each other. Because of its focus on multiple, non-investor stakeholders, TQM does not address the issue of how to make value-maximizing trade-offs among different stakeholder groups. It fails to provide answers to questions such as: What is the value to shareholders of the increase in employees' human capital created by corporate investments in quality-training programs? And, given that a higherquality product generally costs more to produce, what is the value-maximizing quality-cost combination for the company? The failure of TQM to address such questions may be one of the main reasons why the adoption of TQM does not necessarily lead to improvements in EVA. Because a financial management tool like EVA has the ability to guide managers in making trade-offs among different corporate stakeholders, it can be used to complement and reinforce a TQM program. By subjecting TQM to the discipline of EVA, management is in a better position to ensure that its investment in TQM is translating into increased shareholder value. At the same time, a TQM program tempered by EVA can help managers ensure that they are not under investing in their non-shareholder stakeholders.     

Top Management Incentives and Corporate Performance

There is little agreement about either the effect of executive compensation on corporate performance or the best way to measure the strength of executive incentives. With little guidance from academic research, managers and directors continue to rely heavily on the percentage of pay "at risk" as a proxy for incentive strength.
Starting with the premise that managers, like investors, are motivated by prospective changes in their wealth, this article presents a measure of incentive strength called "wealth leverage" that reflects the sensitivity of an executive's company-related wealth—total stock and option holdings plus the present value of expected future compensation, including future salary, bonus and stock compensation—to changes in shareholder wealth. After estimating top management's wealth leverage at 702 companies, the authors conclude that: 1) the median company has significant wealth leverage; 2) almost all corporate wealth leverage comes from their accumulated stock and option holdings, not from current compensation; and 3) companies with higher wealth leverage significantly outperform their industry competitors.     

It's Showtime: Do Managers Report Better News Before Annual Shareholder Meetings?

Annual shareholder meetings provide an opportunity for shareholders to express their concerns with corporate performance, pressuring managers to demonstrate good performance. We show that managers respond to the shareholder pressure by reporting positive corporate news before the annual shareholder meetings. Specifically, we find significantly positive average cumulative abnormal returns (CARs) during the 40 days before the annual meeting date. The premeeting returns are significantly higher when shareholder discontent with managerial performance is likely to be stronger. The decile of companies with the worst past stock price performance exhibits average CARs of 3.4% and buy‐and‐hold returns of 7.0% during the 40‐day premeeting period. Companies with poor past performance exhibit even higher premeeting returns when shareholder pressure on management is greater, such as when institutional ownership is high, when CEO compensation is high, and when shareholders submit proxy proposals on corporate governance. We complement the evidence based on CARs by showing how managers of poorly performing firms manage the timing and content of earnings announcements and management forecast announcements before the annual shareholder meetings. Overall, the results suggest that managers attempt to influence shareholders before annual shareholder meetings through positive news.     

Voluntary Disclosures,Corporate Control,and Investment

We examine the valuation and capital allocation roles of voluntary disclosure when managers have private information regarding the firm’s investment opportunities, but an efficient market for corporate control influences their investment decisions. For managers with long‐term stakes in the firm, the equilibrium disclosure region is two‐tailed: only extreme good news and extreme bad news is disclosed in equilibrium. Moreover, the market’s stock price and investment responses to bad news disclosures are stronger than the responses to good news disclosures, which is consistent with the empirical evidence. We also find that myopic managers are more likely to withhold bad news in good economic times when markets can independently assess expected investment returns.     

Additional Evidence on the Association Between Director Stock Ownership and Incentive Compensation

Governance scholars argue that outside directors have little incentive to monitor managers when their equity stake in the firm is not significant. A sample with a substantial level of outside director shareholdings is examined and a negative relationship between incentive compensation and outside director stock ownership is found. While firms pay higher incentive compensation when they have greater investment opportunities, the compensation contains excess pay due to ineffective corporate governance. Overall, the results suggest more effective corporate governance and lower incentive compensation when outside director stock ownership is higher.     

Effect of mandatory pro forma earnings disclosure on the relation between CEO share bonuses and firm performance

This paper examines the effect of mandatory pro forma earnings disclosure on the alignment of CEO share bonuses and firm performance (i.e., annual stock returns). Using 6,583 executive-level observations from 986 non-financial firms in Taiwan over the period 1999–2004, we find a significant shift in the CEO share bonus pay-earnings relation caused by a marked reduction in bonus shares after the new disclosure rule becomes effective. The change in CEO compensation structure in turn leads to a closer link between CEO stock bonuses and annual stock returns. The result suggests that a more transparent earnings disclosure could positively affect board choices regarding compensation arrangements, thus inducing a better convergence of manager and shareholder interests.     

The Validity of the Economic Value Added Approach: an Empirical Application

This study investigates the relative explanatory power of the Economic Value Added (EVA) model with respect to stock returns and firms' market value, compared to established accounting variables (e.g. net income, operating income), in the context of a small European developing market, namely the Athens Stock Exchange, in its first market‐wide application of the EVA measure. Relative information content tests reveal that net and operating income appear to be more value relevant than EVA. Additionally, incremental information tests suggest that EVA unique components add only marginally to the information content of accounting profit. Moreover, EVA does not appear to have a stronger correlation with firms' Market Value Added than the other variables, suggesting that – for our Greek dataset – EVA, even though useful as a performance evaluation tool, need not necessarily be more correlated with shareholder's value than established accounting variables.     

The Evolution of Executive Pay Policy at General Motors, 1918–2008

This article documents the gradual movement of General Motors away from the partnership concept that dominated U.S. corporate pay policy in the first half of the 20th century and toward the “competitive pay” concepts that have prevailed since then. The partnership concept was achieved by paying managers bonuses in the form of GM shares, with the amounts paid out of a single company‐wide bonus pool and based on a fixed share of profit (after subtracting a charge for the cost of capital). Thanks to this “EVA‐like” bonus scheme, GM's managers effectively became “partners” with the company's shareholders, sharing the wealth in good times but also the pain in troubled times. What's more, the authors also show that, from the establishment of the program in 1918 through the 1950s, the directors went to great lengths—including several bouts of innovative (and often complex) problem‐solving—to achieve their compensation objectives while maintaining such fixed‐share bonuses. But the sharing philosophy and associated compensation practices were gradually supplanted by competitive pay practices from the 1960s onward. The authors show that by the late 1970s, GM had a board of directors with modest shareholdings, in contrast to the board in the early post‐war period, whose directors had large stakes. As a consequence, directors began acting less like stewards of capital and more like employees whose financial rewards came not from returns on GM's stock but from the fees they received for their services. This fundamental change in board compensation almost certainly contributed to the gradual abandonment of fixed‐profit sharing for GM's managers. In its place, the board implemented competitive pay policies that, while coming to dominate executive pay policy in the U.S. and abroad, have largely divorced executive pay from changes in shareholder wealth. In the case of GM, this growing separation of pay from performance was accompanied by a significant decline in corporate returns on operating capital as well as stock returns over time.     

The Wealth Effects of Capital Investment Decisions: An Empirical Comparison of Korean Chaebol and Non‐Chaebol Firms

Abstract:   This paper investigates the capital investment decisions of Korean firms and their impact on shareholder wealth. Overall, we find positive abnormal returns surrounding the announcements of 697 cases of investment projects during the period 1992–1999. This paper also finds that the investment decisions of business group ( chaebol ‐affiliated) firms do not increase shareholder wealth, while the capital investment decisions of non‐ chaebol firms generate significantly positive abnormal returns. The multivariate tests provide consistent evidence that the announcement effects for chaebol firms are lower than for non‐ chaebol firms, after growth opportunities, investment size and firm size are controlled for. The findings support the view that the organizational structure of Korean chaebols creates an incentive for managers to make non‐value maximizing capital investment decisions.     

Do shareholder agreements affect market valuation?: Evidence from Brazilian listed firms

Shareholder agreements are contracts that govern the relationship among different shareholders in a firm. This article uses a unique dataset to analyze shareholder agreements in listed companies and shows how they affect firm valuation. While shareholder agreements may be used to expropriate value from non-controlling investors, they can also mitigate conflicts of interest and protect minority shareholders. The analysis of a broad time-series and cross-section of Brazilian listed firms provides evidence that the latter effect dominates. We build a shareholder agreement index in order to measure on a firm-level basis the degree of investor protection granted by shareholder agreements. Companies with shareholder agreements have higher valuation and the degree of investor protection granted by shareholder agreements is positively related to firm value, even after controlling for the endogeneity of the firm's decision to adopt shareholder agreements.