A+ Evidence on EVA 1

Transcription

1 A+ Evidence on EVA 1

2 Residual Income Goal: Help a firm to create wealth for its owners. Main focus: Earning generates from invested capital > cost of capital Consider both cost of debt, and cost of equity. Residual Incomet (RIt) = NOPATt [WACCt CAPITALt 1] 3 main ways to increase RI and owners s wealth: Increase NOPAT and ROA Decrease WACC Reallocate capital away from negative-spread toward positive-spread investments. 2

3 EVA RI EVA Introduced by Stern Stewart. One of the metrics follow the concept of residual income, both consider cost of capital. Investors strive to have each of their investments provide a return greater than the returns of the alternative opportunities available. The rate of return for these other opportunities is called the cost of capital. Opportunity cost = Cost of capital 3

4 Residual income (RI) vs EVA Both EVA and residual income consider opportunity costs and use cost of capital. Difference: EVA is the more complicated calculation, it makes more adjustments to the accounting measures of the investment. Adjusments: Adjust the NOPAT and capital components of RI. Enhance comparability and reduce distortions of managerial incentives introduces by GAAP accounting. Kinds of adjustments: Undo traditional accounting accruals. Switch accrual methods. Introduce new accruals not used in GAAP. 4

5 RI, EVA vs NI, CFO Residual income (and EVA) includes the charge of equity capital, which NI and CFO ignored. OLD QS: Is RI and EVA better than NI in explaining firm values and stock returns? Problem: The basis for estimating future RI is only past and current data. NEW QS: Which measure conveys more information about future RI? - current RI - current EVA - current earnings (NI) - other metrics 5

6 Claims about EVA & RI Claim #1: EVA better explains stock returns and firm values. Claim #2: EVA better motivates managers to increase shareholder wealth. 6

7 Claim #1: EVA better explains stock returns and firm values. Q1: Do EVA and/or RI dominate earnings (NI) and operating cash flow (CFO) in explaining contemporaneous stock returns? NO! NI is significantly more highly associated with market-adjusted annual stock returns. (Adj. R-squared = NI-13%, RI-7%, EVA-6%, CFO-3%) Q2: Do components unique to EVA or RI help explain contemporaneous stock returns beyond that explained by CFO and NI? NO! Components unique to EVA (capital charge, accounting adjustments)contribute only marginally to the information already available to market participants in NI. Neither EVA nor RI appears to dominate NI in its association with stock market returns. 7

8 Claim #1: EVA better explains stock returns and firm values. Q3: Does EVA dominate earnings in explaining firm values? NI is significantly more highly associated with firm value. (Adj. R-squared = NI-53%, EVA-50%, NOPAT-49%) NI more often dominates EVA in value-relevance to market participants. Why don t EVA and RI beat NI? 1) EVA s adjustments to GAAP earnings undo informative accounting accruals contained in earnings. (ex: bad debts, deferred taxes.) 2) EVA and RI contain little news beyond that already contained in earnings. 3) Market participants had yet to recognize the information contained in EVA and RI. NO! 8

9 Claim #2: EVA better motivates managers to increase shareholder wealth. Q4: Does asset turnover increase for firms adopting residual income-based compensation plans (relative to non-adopters)? YES! Asset turnover increased by 14%. Operating decisions that used invested capital more efficiently will boost NOPAT, ROA and increase RI. Improve operating efficiency by increasing asset turnover. Investing decisions boost RI to the extend the firm reallocate capital away from activities that earn < capital costs, towards activities that earn > capital costs. 9

10 Claim #2: EVA better motivates managers to increase shareholder wealth. Q5: Do asset dispositions increase and asset acquisitions decrease for firms adopting residual income-based compensation plans (relative to non-adopters)? Asset dispositions increased 100%, new investments decreased 21%. YES! Dispose of selected assets and reduce new investment. Adds value to firm since these assets were failing to earn adequate returns when compared to the firm s overall cost of capital. *Arguments: Reduction in net investment = value increasing action? (It is possible that,anagers actually reduce the positive NPV projects. ) 10

11 Claim #2: EVA better motivates managers to increase shareholder wealth. Q6: Do share repurchases and dividend payouts increase for firms adopting residual income-based compensation plans (relative to non-adopters)? YES! Share repurchases increased 112%, dividends per share increase 1%. Financial decisions is affected. Given that holding capital that earns less than the WACC reduces RI, we expect to observe increased payouts to shareholders. Repurchase more shares. (consistent with distributing underperforming capital to shareholders ) 11

12 Claim #2: EVA better motivates managers to increase shareholder wealth. Q7: Does residual income increase for firms adopting residual income-based compensation plans (relative to non-adopters)? YES! RI firms relative to the control firms increased residual income by a statistically significant average of nearly $190 million annually (almost 1300%). Conclusion: By adopting RI incentive plans, firms observed a increase in RI, and believed to get what you measure and reward. RI-based plans change managers operating, investing and financing decisions. Prove RI create shareholder wealth. Provide precondition for shareholder wealth creation. 12

13 Conclusion Claim #1: EVA better explains stock returns and firm values. Disapproved Claim #2: EVA better motivates managers to increase shareholder wealth. Approved EVA and RI could prove effective in motivating shareholder wealth creation without conveying new information to investors. 13

14 Evidence on EVA 政大企研碩二 A 趙峻廷 Theory EVA attempt to measure an underlying concept called residual income. 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. Residual income measures profits net of the full cost of both debt and equity capital. RI t=nopat t (WACC t x CAPITAL t-1) RI t=(roa t x CAPITAL t-1)-(wacc t x CAPITAL t-1) RI t=(roa t WACC t ) x CAPITAL t-1 RI t=ni t (k t x BV t-1), where BV=book value There are three ways to increase residual income and owners wealth: a) increase residual income to the extent they increase NOPAT and ROA b) decrease WACC c) reallocate capital away from negative spread toward positive spread investments EVA First introduce in late 1980s by Stern Stewart. To compute economic value added, Stern Stewart adjusts the NOPAT and capital components of residual income for what are termed accounting anomalies or distortions. Some of these adjustments undo traditional accounting accruals. Other adjustments switch accrual methods. Still others introduce new accruals not used in traditional GAAP-based accounting. Stern Stewart said 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. For example, certain adjustments remove or reduce managers discretion in computing EVA. Other adjustments reduce incentives to make operating, investing, and financing choices that boost earnings and EVA in the short term, but reduce shareholder wealth. Interestingly, although the sample is drawn from among the largest firms in the U.S. economy, median EVA is negative until 1995, and median RI is negative in every year. Near zero EVA and RI is consistent with a competitive economy in which even the typical large firm has difficulty earning more than its cost of capital.

15 政大企研碩二 趙峻廷 CLAIM 1: EVA better explains stock returns and firm value, true or false? They better explain stock returns and firm values than traditional accounting earnings. They better motivate managers to create shareholder wealth. Evidence on associations w/ stock returns and firm values Q1: Do EVA and/or RI dominate NI and operating cash flow in explaining contemporaneous stock returns? implement by using adjusted R-squared from a regression of stock returns on each performance metric. Result: Current period accounting earnings (NI) is significantly more highly associated with market-adjusted annual stock returns than are RI and EVA, and that all three dominate cash flows from operations. NI appears to outperform EVA on average. Q2: Do components unique to EVA or RI help explain contemporaneous stock returns beyond that explained by NI and CFO? we decompose EVA into its component parts, such as operating accruals, and capital charge, and then we evaluate the contribution of each component toward explaining contemporaneous stock returns. EVA components add little to the explanatory power of the regressions. while traditional earnings components such as operating cash flow and accruals are consistently significant, components unique to EVA, that is, the capital charge and accounting adjustments are often not significant in explaining contemporaneous returns. the result suggest that EVA components contribute only marginally to the info already available to market participants in NI. NI has the largest relative info content, meaning that there s little incremental info content in EVA, RI, and CFO beyond that contained in NI. Q3: Does EVA dominate earnings in explaining firm values? we replicate and extend a study authored by former Stern Stewart vice president, who adjusted the EVA regression by: a) allowing separate coefficients for positive and negative values of EVA b) including the natural log of capital in an attempt to capture differences in the way the market values firms of different sizes

16 政大企研碩二 趙峻廷 c) including 57 industry dummy variables in order to capture potential industry effects. Result: when this adjustment is only used on EVA but NOPAT, there s a larger Adj R- squared for the EVA than NOPAT, yet when all are adjusted, NI>EVA>NOPAT Earning more often dominates EVA in value-relevance to market participants. Reason why Residual income and EVA don t beat earnings: a) The valuation model is specified in terms of discounted future RI(or EVA) not on past and current realizations, meaning realized earnings are a better predictor of future EVA than realized EVA itself. b) Earnings could dominate RI if market participants use cost of capital that are different than those provided by Stern Stewart. c) The market may make a set of accounting adjustments that are different from those applied by Stern Stewart. d) It s also possible that, for time period we studied, the market had yet to recognize valuable incremental info contained in EVA and RI numbers. CLAIM 2: EVA better motivates managers to increase shareholder wealth, true or false? Because it can be shown that discounted future RI is equivalent to discounted future cash flows in a capital budgeting decision, RI-based incentives are claimed to better motivate managers to select positive net-present-value(npv) investments than traditional accounting metrics. Evidence on incentives and performance evidence consistent w/ this precondition doesn t prove that RI(or EVA) creates shareholder s wealth but it provides a necessary first step by demonstrating that RIbased 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 w/ residual income incentives to increase asset turnover measured by sales over total assets. Q4: Does asset turnover increase for firms adopting residual income-based compensation plans? total asset turnover increased by adopting residual income plans relative to control firms in the period after adoption. Investing decisions also boos RI to the extent they re-allocate capital away from

17 政大企研碩二 趙峻廷 activities that earn less than their capital costs and toward activities that earn more. Q5: Do asset dispositions increase and asset acquisitions decrease for firms adopting residual income-based compensation plans? each of these changes is significant at conventional levels. However, it is difficult to interpret whether an observed reduction in net investment is a value-increasing action since it is possible that managers are reducing positive NPV projects, not just projects earning below their cost of capital. Q6: Do share repurchases and dividend payouts increase for firms adopting residual income-based compensation plans? Managers faced w/ higher investment hurdle rates under RI return excess capital to shareholders in a tax-favored manner that does not signal a permanent change in dividend payout. if managers take actions consistent w/ RI incentives, firms that adopt RI incentives should produce increased residual income. Q7: Does residual income increase for firms adopting residual income-based compensation plans? Although the result suggest that the adoption of residual income-based incentives alter management decisions in ways that should contribute to shareholder wealth, several caveats are in order. a) Firms that adopt new incentive plans may simultaneously change other aspects of their operations that also could influence management decisions, thus observed changes in management behavior could be due at least in part to these other effects. b) The sample is not random since firms choose voluntarily to adopt residual income-based plans. c) While they suggest changes in management behavior that are consistent w/ RI incentives, it remains for future research to confirm that resulting benefits have been realized by shareholders. Conclusion Regarding the first claim that EVA is more closely associated w/ stock returns and firm value than is net income (NI), research suggests that EVA (RI) does not dominate traditional accounting earnings in associations w/ stock returns and firm values. On the contrary, earnings generally beats EVA in value relevance to market participants.

18 政大企研碩二 趙峻廷 Regarding the second claim that EVA and residual income better motivate managers to increase shareholder wealth, firm that adopt residual incomebased incentives rend to: a) Improve operating efficiency by increasing asset turnover b) Dispose of selected assets and reduce new investment c) Repurchase more shares Firms that adopt RI incentive plans also exhibit increased residual income, confirming the adage that you get what you measure and reward. these findings support a pre-condition for shareholder wealth creation by confirming that managers respond to RI-based incentives. Is it possible that residual income-based incentives can motivate mangers to take actions consistent w/ shareholder wealth creation when earnings beats EVA and residual income in associations w/ stock returns and firm values? YES. The best performance measure is the one that w/o imposing excessive costs fives managers the strongest incentives to take actions that increase firm value. EVA and residual income could prove effective in motivating shareholder wealth creation w/o conveying new info to investors and claims linking the two should be interpreted w/ care. If an internal metric or compensation plan is more effective in motivating shareholder wealth creation, shareholders should benefit regardless of its correlation w/ stock returns and firm values.