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The Optimal and Actual Use of EVA versus Earnings in Actual Compensation

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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

    Proponents of EVA and related "shareholder value" measures intend to replace earnings and to supplement stock returns by including their own measures in managerial compensation schemes. Stern Stewart's EVA appears to be the most widely recognized measure. However, there are not very many firms have explicitly adopted such schemes. One obvious reason, which we account for explicitly, is that they are not appropriate for all firms. An additional, less obvious fact, is that firms can directly or even indirectly mimic EVA measures. Firms such as Clorox and O.M. Scott use their own performance measures, which are arguably variants of EVA. In this paper, we use publicly available estimates of firm level EVA and examine whether firms pay according to it regardless of their explicit policies. This research approach captures the fact mentioned above, that firms can do home-made EVA performance evaluation. We adapt the technique of Garvey and Milbourn (2000) to model the optimal weight placed on EVA at the firm level. There is enormous cross-sectional heterogeneity in the estimated "value-added" of EVA for various firms. With our estimates of optimal weights, we verify empirically that compensation paid to the top five executives in over 2,000 firms is highly consistent with our optimal compensation arrangements.

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    Bibliographic Info

    Paper provided by Claremont Colleges in its series Claremont Colleges Working Papers with number 2000-53.

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    Date of creation: 2000
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    Handle: RePEc:clm:clmeco:2000-53

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    1. Paul, Jonathan M, 1992. "On the Efficiency of Stock-Based Compensation," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 471-502.
    2. Bikhchandani, Sushil & Hirshleifer, David & Welch, Ivo, 1992. "A Theory of Fads, Fashion, Custom, and Cultural Change in Informational Cascades," Journal of Political Economy, University of Chicago Press, vol. 100(5), pages 992-1026, October.
    3. Michael C. Jensen & Kevin J. Murphy, 1990. "Ceo Incentives - It'S Not How Much You Pay, But How," Journal of Applied Corporate Finance, Morgan Stanley, vol. 3(3), pages 36-49.
    4. Robert T. Kleiman, 1999. "Some New Evidence On Eva Companies," Journal of Applied Corporate Finance, Morgan Stanley, vol. 12(2), pages 80-91.
    5. Yermack, David, 1995. "Do corporations award CEO stock options effectively?," Journal of Financial Economics, Elsevier, vol. 39(2-3), pages 237-269.
    6. Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, vol. 55(2), pages 303-28, March.
    7. Jensen, M.C. & Murphy, K.J., 1988. "Performance Pay And Top Management Incentives," Papers 88-04, Rochester, Business - Managerial Economics Research Center.
    8. Ross, Stephen A, 1973. "The Economic Theory of Agency: The Principal's Problem," American Economic Review, American Economic Association, vol. 63(2), pages 134-39, May.
    9. Joseph G. Haubrich, 1991. "Risk aversion, performance pay, and the principal-agent problem," Working Paper 9118, Federal Reserve Bank of Cleveland.
    10. Garen, John E, 1994. "Executive Compensation and Principal-Agent Theory," Journal of Political Economy, University of Chicago Press, vol. 102(6), pages 1175-99, December.
    11. Fama, Eugene F. & French, Kenneth R., 1997. "Industry costs of equity," Journal of Financial Economics, Elsevier, vol. 43(2), pages 153-193, February.
    12. Bengt Holmstrom, 1997. "Moral Hazard and Observability," Levine's Working Paper Archive 1205, David K. Levine.
    13. 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.
    14. Sloan, Richard G., 1993. "Accounting earnings and top executive compensation," Journal of Accounting and Economics, Elsevier, vol. 16(1-3), pages 55-100, April.
    15. Gerald T. Garvey & Todd T. Milbourn, 2000. "EVA versus Earnings: Does it Matter which is More Highly Correlated with Stock Returns?," Claremont Colleges Working Papers 2000-52, Claremont Colleges.
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