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EVA versus Earnings: Does it Matter which is More Highly Correlated with Stock Returns?

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  • Gerald T. Garvey

    (Drucker Graduate School of Management, Claremont Graduate University)

  • Todd T. Milbourn

    (Olin School of Business, Washington University)

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    Abstract

    Dissatisfaction with traditional accounting-based performance measures has spawned a number of alternatives, of which Economic Value Added (EVA) is clearly the most prominent. How can we tell which performance measures best capture managerial contributions to value? There is currently a heated debate among practitioners as to whether the new performance measures have a higher correlation with stock values and returns than do traditional accounting earnings. Academic researchers have instead relied on the variance of performance measures to gauge their relative accuracy. Our analysis pits EVA against earnings as two candidate performance measures. We use a relatively standard principal-agent model, but recognize that while the variability of each measure is observable, their exact information (signal) content is not. The model provides a formal method for ascertaining the relative value of such measures based on two distinct uses of the stock price. First, as is well-known, prices provide a noisy measure of managerial value-added. Our novel insight is that stock prices can also reveal the signal content of alternative accounting-based performance measures. We then show how to combine stock prices, earnings, and EVA to produce an optimally weighted compensation scheme. Surprisingly, we find that the simple correlation between EVA or earnings and stock returns is a reasonably reliable guide to their value as an incentive contracting tool. This is not because stock returns are themselves an ideal performance measure, rather it is because correlation places appropriate weights on both the signal and noise components of alternative measures. We then calibrate the theoretical improvement in incentive contracts from optimally using EVA in addition to accounting earnings at the firm and industry level. That is, we empirically estimate the "value-added" of EVA by firm and industry. These estimates are positive and significant in predicting which firms have actually adopted EVA as an internal performance measure.

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    Bibliographic Info

    Paper provided by Claremont Colleges in its series Claremont Colleges Working Papers with number 2000-52.

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    Date of creation: 2000
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    Handle: RePEc:clm:clmeco:2000-52

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    6. Rajesh K. Aggarwal & Andrew A. Samwick, 1999. "The Other Side of the Trade-off: The Impact of Risk on Executive Compensation," Journal of Political Economy, University of Chicago Press, vol. 107(1), pages 65-105, February.
    7. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
    8. Robert T. Kleiman, 1999. "Some New Evidence On Eva Companies," Journal of Applied Corporate Finance, Morgan Stanley, vol. 12(2), pages 80-91.
    9. Haubrich, Joseph G, 1994. "Risk Aversion, Performance Pay, and the Principal-Agent Problem," Journal of Political Economy, University of Chicago Press, vol. 102(2), pages 258-76, April.
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    Cited by:
    1. Saadet Kasman & Adnan Kasman, 2011. "Efficiency, Productivity and Stock Performance: Evidence from the Turkish Banking Sector," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 58(3), pages 355-372, September.
    2. Sergio Destefanis & Vania Sena, 2007. "Patterns of corporate governance and technical efficiency in Italian manufacturing," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 28(1), pages 27-40.
    3. Yong Tan & Christos Floros, 2012. "Stock market volatility and bank performance in China," Studies in Economics and Finance, Emerald Group Publishing, vol. 29(3), pages 211-228, August.
    4. Verbeeten, F.H.M., 2005. "New’ Performance Measures: Determinants of Their Use and Their Impact on Performance," ERIM Report Series Research in Management ERS-2005-054-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.
    5. Gerald T. Garvey & Todd T. Milbourn, 2000. "The Optimal and Actual Use of EVA versus Earnings in Actual Compensation," Claremont Colleges Working Papers 2000-53, Claremont Colleges.
    6. Fiordelisi, Franco, 2007. "Shareholder value efficiency in European banking," Journal of Banking & Finance, Elsevier, vol. 31(7), pages 2151-2171, July.
    7. Carretta, Alessandro & Farina, Vincenzo & Fiordelisi, Franco & Schwizer, Paola, 2006. "Corporate culture and shareholder value in banking industry," MPRA Paper 8304, University Library of Munich, Germany.
    8. David Sparling & Calum G. Turvey, 2003. "Further thoughts on the relationship between economic value added and stock market performance," Agribusiness, John Wiley & Sons, Ltd., vol. 19(2), pages 255-267.
    9. Ittner, Christopher D. & Larcker, David F., 2001. "Assessing empirical research in managerial accounting: a value-based management perspective," Journal of Accounting and Economics, Elsevier, vol. 32(1-3), pages 349-410, December.

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