Summary of the article Evidence on EVA Handed in by Arcan Orak, matriculation number:

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1 Summary of the article Evidence on EVA Handed in by Arcan Orak, matriculation number: A+ 1 Introduction The article Evidence on EVA is primarily concerned with the examination of evidence for two claims about EVA and residual income: Claim 1) EVA and residual income better explain stock returns and firm values than traditional accounting measures. Claim 2) Compensation plans based on residual income better incentivize managers to create shareholder value. The basic idea of residual income is that firms have to earn more on their total invested capital than the cost of that capital to create shareholder value whereas EVA is a metric that attempt to measure the residual income. The major difference between EVA and residual income is that the NOPAT and components of residual income are adjusted for accounting anomalies or distortions to compute the EVA. Examples are that the adjustments undo traditional accounting accruals or the capitalization and amortization of marketing and R&D expenses. These adjustments help to increase the comparability and to reduce incentives for managers to think too much in the shortterm resulting in a decrease of the shareholder value in the long-term (e.g. boosting earnings and EVA in the short-term with bad debt accruals). However, the paper shows that within a period of about 10 years the difference between EVA and residual income was marginal, suggesting that the adjustment effects are not large on average. In contrast to the traditional accounting net income, which measures profits net of interest expense on debt capital, residual income measures profits net of the full costs of both debt and equity capital. Residual income is measured as follows: Residual income = NOPAT - WACC*Capital or (ROA WACC)*Capital. In other words, if the return on assets is higher than the WACC, a firm produces positive residual income. There are three ways to increase the residual income: First, increase ROA and NOPAT. Second, decrease WACC or Third, earn a positive spread between ROA and WACC. All three opportunities are incentives for managers that are compensated based on Residual income (or EVA). 1

2 A major problem of residual income or EVA is that stock market participants can only rely on past and current data to estimate the future residual income. Thus, the research question arises whether current residual income and EVA or current earnings convey more information about the future residual income. 2 Main findings Claim 1 Coming back to the two claims, the paper examines recent independent evidence that bears on the claims. To provide evidence on the first claim, the paper compares EVA and residual income with the net income and cash flow from operations. In more detail, the paper examines three related questions. A sample of more than 6000 firms over a period of about 10 years shows that net income dominates the residual income, EVA and cash flows regarding the relevant information content. Furthermore, the paper finds out that components unique to EVA (capital charge and accounting adjustments) are not significant in explaining contemporaneous returns which means that EVA components contribute marginally to the information that are made available to market participants by the net income. It becomes clear that neither EVA nor residual income dominate the net income in its association with stock market returns and that EVA and residual income have only little information beyond that contained in net income. To finalize the answer of the first claim, the paper reflects that earnings better explain firm values than the EVA. Three points are made by the authors to explain why residual income and EVA do not beat earnings: 1) Realized earnings are a better predictor of future EVA than the EVA itself. 2) Market could use different cost of capital estimates and accounting adjustments and not the ones provided by Stern Stewart in the theory. The earnings convey the most essential information (unexpected revenues and costs) while EVA and residual income do not convey additional information. Thus, the same assumptions regarding the cost of capital estimates and accounting adjustments would not lead to another conclusion. 3) For the time period studied, the market had yet to recognize the important information contained in EVA and residual income numbers. 2

3 Claim 2 The second claim states that EVA better motivates managers to increase shareholder value as it better aligns the internal management incentives with owners interests. In the provided literature some preconditions are set for the possibility that managers of firms adopting the residual income-based plan create shareholder value. The preconditions are that managers change their operating, investing and financing decisions. Even the evidence consistent with these preconditions does not prove that residual income (or EVA) increases shareholder value, it provides a necessary step that residual income-based incentive compensation plans are important to change management decisions. The authors compared the incentive effects on different figures (Asset Turnover/Disposition/Investments, Share Repurchases and Dividends per Share) of 40 firms that adopted residual income-based compensation plans with 40 firms that use traditional compensation plans to question the second claim. The adoption of residual income-based compensation plans has positive effects on all parts, except the asset investments. In terms of asset investments, it is difficult to point out whether it is value-increasing or not. Even the results suggest that the adoption of residual incomebased incentives change management decisions in a manner that should increase the shareholder wealth, there are several caveats: 1) Firms, adopting new incentive plans could also change other aspects of their operations which in turn influence management decisions (e.g. restructurings and strategic repositioning). Thus, the changed management behavior could be due to these other aspects rather than to the new compensation plan. 2) No random sample but deliberately chosen companies that voluntarily adopted residual income-based compensation plans. 3) It is not clear whether the resulting benefits of the residual income-based compensation plans have been realized by the shareholders. 3 Own View and key learning Overall, the two claims are disproved or at least questioned. The evidences on both claims do not support them fully. In my personal view, it was surprising that the accounting way with the net income dominates the practical way with the residual 3

4 income (or EVA) which is used by well-known companies and managers. I would have expected that the residual income respectively EVA conveys additional valuable information for shareholders since it is used for years in the practice by those wellknown companies like Coca-Cola. As the second reading The real key to creating wealth showed me, some companies strongly believe that the implementation of the EVA created shareholder value for them whereas this reading Evidence on EVA strongly disagrees with it. My key learning from this reading is that it is not contradictory that residual incomebased compensation plans can motivate managers to create shareholder value even residual income or EVA are dominated by earnings in association with stock returns and firm values. This means that residual income or EVA can motivate shareholdervalue creation without conveying additional new information to shareholders which justifies the popularity of this management tool. Nevertheless, the article does not clearly point out if shareholders benefit from residual income-based compensation plans. It would be very interesting for me in the future to get an answer to this question. 4

5 Corporate Finance Neeti Dixit A+ Evidence on EVA Summary Economic Value Added (EVA), a measuring technique developed by Stern Stewart & Company in the 1990s, assesses and estimates company evaluations and managerial appraisals. It has been long debated that EVA is actually repackaged Residual Income, a term in usage for eons in the financial world. Residual income is the remaining income generated over the required rate of return. The rebranding of residual income did create a storm and generated massive popularity of EVA amongst industry leaders such as Coca Cola, Kellogg s, and Eli Lilly. Along with its popularity as a valuation metric, there has been a debate if EVA stands by its claims of being superior to other commonly used metrics such as Net Income, Cash flow from Operating Activities, and Residual Income. Residual Income & EVA brief description: Residual Income measures the economic value created by an entity/asset over and above the required cost of capital. It aims at finding out the increment in the shareholder s wealth caused by an asset s activities. RI t = NOPAT t WACC t * Capital employed t-1 where: RI = Residual Income; NOPAT = net operating profit after taxes; WACC = weighted average cost of capital We can see that NOPAT is essentially EBIT where interest is added and statutory taxes are removed to check the operating profits generated by the core business without removing the cost of debt (to remove any effect of debt in the capital structure). The core business utilizes funding from both equity and debt generated funds and hence it is checked against the overall cost of capital i.e. WACC multiplied by the total capital invested to arrive at a $ value of residual income. Rewriting the above equation as (ROA t WACC t )* Capital employed t-1 where:

6 Neeti Dixit ROA = Return on Assets A positive dollar value indicates value creation for the investors. To put residual income in terms of accounting, it is the change in the book value of equity, an equity bought with an associated cost. We can rewrite the above equation as: RI t = Net Income t (NI) (k t * BV t-1 ) where, k e is the associated cost of equity and BV is the beginning value of equity for that period. A positive dollar value indicates increasing wealth for shareholder. Digging deeper in defining residual income s relation with a shareholder s wealth, we can evaluate market value of equity through DDM (discounted dividend model), where we compute the summation of present value of expected dividends in future. V t = Σ =1 -> D 1+ / (1+k) where V = market value of equity; D = dividend; = time Rewriting the above equation in accounting terms, current equity value is the sum of equity value in period beginning plus net income after dividend reductions. Combining the above-mentioned financial and accounting interpretations of residual income and net income, we arrive at V t = Σ τ=1 τ = [RI t+τ + (1 + k)bv t+τ 1 BV t+τ ]/(1 + k) τ (under the assumption using limits, the function BV t+τ ]/(1 + k) τ approaches 0 as approaches infinity) leads to the following value of equity : Vt = BVt + Στ=1 τ = RIt+τ/(1 + k) τ where clearly V t holds for residual income RI as the cost of equity k has been accounted for while an accounting earning does not reflect the cost of equity. While this could make Residual Income or EVA look superior to other metrics but its reliance is shaky as we depend on past and current data to estimate the future residual income. Hence, the question remains if there are other metrics that convey better estimations of future residual income for shareholders benefit. EVA Adjustments & Claims:

7 Neeti Dixit EVA, a trademarked name for residual income, is the best measure for valuation and managerial incentive-based compensation as claimed by Stern Stewart & Co. However, they make certain adjustments that are not part of traditional GAAP. Explained below are a few adjustments below with their result on NOPAT: Adjustment Marketing and R&D: under GAAP, they are recorded as expenses; EVA adjusts them as assets Goodwill: usually recorded as an asset and amortized; EVA records it as asset but applies reverse amortization to original asset value LIFO inventory costing is converted to FIFO Result Recording them as assets and amortizing, capitalizes their values and thus increasing NOPAT Reverse amortizing to reflect original asset value increases the total asset value FIFO records sold inventory at original/older costs and the unsold inventory is recorded at most recent costs resulting in lower COGS and higher asset value Practitioners and advocates of EVA as a superior metric over in-practice metrics, claim the following: 1. EVA offers superior explanation in stock returns and firm valuation 2. EVA is a superior motivator for managers to focus on shareholder wealth maximization We assess each claim with respective arguments: Claim 1 To evaluate the first claim, three related questions were looked at follows: 1. If EVA and/or Residual income dominate traditional measures such as net income or cash flows in explaining stock returns a. A sample of 6,174 companies over a period of were examined. The test of association with stocks was significantly higher with Net Income (Adj. R 2 = 13%) than that of EVA (Adj. R 2 = 6%) and RI (Adj. R 2 = 67%) hence clearly EVA s claim is not justified.

8 Neeti Dixit Do components of EVA and/or Residual income better explain contemporaneous stock returns than traditional measures such as CFO and NI? a. Dissecting EVA and its components do not show a better explanatory relation with stock returns, while traditional measures show consistency in information explaining stock returns. As answered in question one, the largest adjusted R 2 for net income the findings by the researchers explicitly show dominance of NI over EVA and residual income. 3. Does EVA explain firm values better than earnings? a. The researchers replicated the study conducted by Stephen O Byrne, VP, Stern Stewart & Co. to report NOPAT (earnings) with a better goodness of fit (adj R 2 = 33%) wrt EVA at 31% when regressed against firm values. Further, post the adjustments made to achieve better results for EVA, accounting and statistical adjustments helped EVA s adj R 2 to 56% (NOPAT still at 33%). Giving same adjustments to NOPAT gave its adj R 2 a boost to 53% and again suggesting evidence of superiority of earnings over EVA. Claim 2 Does EVA motivate managers to increase shareholder wealth? In a study conducted by James S. Wallace to check contributions of EVA or RI towards shareholder wealth, the findings could not support the claim however did establish that firms, who adopt RIbased incentive compensation plans for their managers, were effective in influencing management decisions. Summarising the findings show the following changes in firms adopting RI-based incentive plans vs control firms with traditional measures % average increase in asset turnover % increase in asset disposition and 21% decrease in new investments % increase in share repurchase and only a 1% percent increase in dividends per share

9 Neeti Dixit Above findings, show an increase in residual income for firms with managers who take actions consistent with RI incentives. There is significant evidence of change in operating, investing, and financing behaviour of managers. Personal View EVA, indeed, is a useful new measuring metric that competes with traditional methods in evaluating performance of a company and its managers. Results have shown its superiority in some aspects such as motivating employees towards the benefit of the firm, if incentivised accordingly (RI and EVA are used interchangeably). There is not enough evidence to support its stock returns claim, given the statistical findings. We must remember that EVA is a trademarked product of a consulting firm selling it as a breakthrough product with glossy examples of the likes of Coca Cola and Kellogg s. These companies are gigantic with massive asset investments. Any change, big or small, in their asset allocation, cost allocation would bring about a noticeable change on their NOPAT with visible effect on EVA. As noticed above, EVA does not give out on any new information to a shareholder that does not reflect in earnings. I would not write off earnings as obsolete. The statistical findings are consistent in their support for earnings as strong competing measure. I also find the required accounting adjustments for EVA calculations overwhelming and difficult to comprehend in passing. Application of EVA for a firm can be a daunting task and need explanations to all the stakeholders in a firm. In addition, a company can make as many adjustments with its practice of accounting methodologies making a peer comparison difficult. Overall, EVA can be utilised internally by a firm as an incentive plan for manager motivation that would eventually reflect on share prices and thus shareholder wealth increment. To call it a breakthrough measure would be denying traditional measures and we do not have enough evidence to say so.

10 THE THEORY A+ EVA is the leading example of a new class of metrics that attempt to measure an underlying concept called residual income. Recognized by economists since the 1770s, residual income is based on the premise that, in order for a firm to create wealth for its owners, it must earn more on its total invested capital than the cost of that capital. 1 Whereas traditional accounting net income measures "profits" net of interest expense on debt capital, residual income measures "profits" net of the full cost of both debt and equity capital. EVA First introduced in the late 1980s, Stern Stewart's EVA has generated considerable publicity and over 300 client adoptions to date, including major inter- national corporations such as Coca-Cola, Eli Lilly, and Siemens.6 EVA also has attracted competitors who offer related or competing metrics. The resulting intense competition has been referred to as 7 metric wars" in the financial press. Figure 1 summarizes the steps that transform underlying cash flows from operations (CFO) into Stern Stewart's economic value added (EVA). Adjusting CFO for accounting accruals (such as depreciation and interest expense) yields bottom line accounting earnings (NI). Adding back after-tax interest expense to NI yields net operating profits after tax (NOPAT). Subtracting the current cost of both debt and equity capital from NOPAT yields residual income (RI). To compute economic value added (EVA), Stern Stewart adjusts the NOPAT and capital components of residual income for what are termed "accounting anomalies" or "distortions. "8 Some of their more common adjustments are shown in Table I. Some of these adjustments undo traditional accounting accruals (such as eliminating deferred tax accounting in favor of actual cash taxes paid). Other adjustments switch accrual methods (e.g. from LIFO to FIFO). Still others introduce new accruals not used in traditional GAAPbased accounting (e.g., capitalization and amortization of marketing and R&D expenditures).

11 Some of their more common adjustments are shown in Table I. Some of these adjustments undo traditional accounting accruals (such as eliminating deferred tax accounting in favor of actual cash taxes paid). Other adjustments switch accrual methods (e.g. from LIFO to FIFO). Still others introduce new accruals not used in traditional GAAPbased accounting (e.g., capitalization and amortization of marketing and R&D expenditures). Stern Stewart argues that these EVA adjustments produce a better measure of residual income that enhances comparability and also reduces distortions of managerial incentives introduced by standard GAAP accounting. 9 For example, certain adjustments remove or reduce managers' discretion in computing EVA (e.g., the opportunity to influence bad debt accruals). Other adjustments reduce incentives to make operating, investing, and financing choices that boost earnings and EVA in the short term, but reduce shareholder wealth. Examples of such myopic decision-making include cutbacks in positivenpv capital investments, marketing, and R&D expenditures. These adjustments are particularly relevant when executive pay is closely linked to EVA a situation that can produce incentives for shortterm "gaming." Other mechanisms used in conjunction with EVA to help control "shorttermism" include bonus banks and E VA-based stock option plans.

12 CLAIM #1 EVA BETTER EXPLAINS STOCK RETURNS AND FIRM VALUES Proponents of EVA and other residual income measures have made two primary claims about EVA and/or residual income: (1) they better explain stock returns and firm values than traditional accounting earnings; and (2) they better motivate managers to create shareholder wealth. According To an independent evidence that bears on each claim, the results do not support the contention that EVA outperforms earnings in explaining firms values. On the contrary, the evidence suggests that earnings more often dominates EVA in value-relevance to market participants. Why Don't Residual Income and EVA "Beat" Earnings? There are several potential explanations as to why RI and EVA do not dominate earnings in associations with stock returns and firm values. First, recall that the valuation model in equation (4b) is specified in terms of discounted future RI (or EVA) not on past and current realizations. In this light, our evidence suggests that realized earnings are a better

13 predictor of future EVA than realized EVA itself. Also recall that the key difference between NI and RI is the cost of equity capital, and that the key difference between RI and EVA are Stern Stewart's accounting adjustments (such as the capitalization of R&D). Earnings could dominate RI if market participants use cost of capital estimates that are different than those provided by Stern Stewart. Earnings could dominate EVA if Stern Stewart's accounting adjustments have the effect of "undoing" discretionary accruals that market participants use to infer firms future prospects. Alternatively, the market may make a set of accounting adjustments that are different from those applied by Stern Stewart. Even if the market adjustments are similar to Stern Stewart's, they may contain little news. If earnings already conveys essential economic news (e.g., unexpected revenues and costs) and the market provides its own cost of capital estimate there may be little left to glean from RI and EVA. It also is possible that, for the time period we studied, the market had yet to recognize valuable incremental information contained in EVA and RI numbers. CLAIM #2 EVA BETTER MOTIVATES MANAGERS TO INCREASE SHAREHOLDER WEALTH A second principal claim is that residual income-based incentive schemes are better than earnings-based plans in motivating managers to create shareholder wealth For example, Stern Stewart advertisements often include testimonials and charts showing rising EVA and share prices. They suggest that EVA adoption is responsible for increased shareholder wealth by better aligning internal management incentives with owners' interests.20 Because it can be shown that discounted future RI is equivalent to discounted future cash flows in a capital budgeting decision, 21 RI-based incentives are claimed to better motivate managers to select positive net-present-value investments than traditional accounting metrics. As we noted earlier, both RI- and EVA-based compensation should reward managers for increasing operating profits (NOPAT) and return on capital (ROA), reducing the weighted average cost of capital (WACC), and reallocating capital from

14 negative spread (ROA minus WACC) activities toward positive spread activities. We next present evidence on whether managers actually respond to these incentives at firms that adopt residual income-based metrics. Evidence on Incentives and Performance In a recently published paper entitled "Adopting Residual Income-Based Performance Plans: Do You Get What You Pay For? "23 Wallace provides independent evidence on this second set of claims. Specifically, he examines what amounts to a precondition for the possibility that managers of firms adopting RI based plans (including EVA) create wealth for their shareholders: namely, that the managers change their operating, investing and financing decisions in response to RI incentives. Evidence consistent with this precondition does not prove that RI (or EVA) creates shareholder wealth, but it provides a necessary first step by demonstrating that RI-based incentive compensation plans are effective in altering management decisions. Operating decisions that use invested capital more efficiently will boost NOPAT and ROA and, other things equal, increase RI. For this reason, we would expect actions consistent with residual income incentives to increase asset turnover measured by sales over total assets. Conclusion EVA provides desirable management incentives under appropriate conditions. The only concerns are the following claims: That EVA explains stock returns and firm values better, and that motivates managers to increase shareholders wealth better. The study also claims that EVA does not dominate traditional earnings. Both EVA and residual income should improve operating efficiency by increasing asset turnover, make new investments and repurchase shares.

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