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

  • Gerald T. Garvey

    (Drucker Graduate School of Management, Claremont Graduate University)

  • Todd T. Milbourn

    (Olin School of Business, Washington University)

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    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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    File URL: http://www.claremontmckenna.edu/rdschool/papers/2000-53.pdf
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    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. Sushil Bikhchandani & David Hirshleifer & Ivo Welch, 2010. "A theory of Fads, Fashion, Custom and cultural change as informational Cascades," Levine's Working Paper Archive 1193, David K. Levine.
    2. Jensen, Michael C & Murphy, Kevin J, 1990. "Performance Pay and Top-Management Incentives," Journal of Political Economy, University of Chicago Press, vol. 98(2), pages 225-64, April.
    3. Robert T. Kleiman, 1999. "Some New Evidence On Eva Companies," Journal of Applied Corporate Finance, Morgan Stanley, vol. 12(2), pages 80-91.
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    5. 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.
    6. 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.
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    9. Bengt Holmstrom & Paul R. Milgrom, 1985. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Cowles Foundation Discussion Papers 742, Cowles Foundation for Research in Economics, Yale University.
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    13. Rogerson, William P, 1997. "Intertemporal Cost Allocation and Managerial Investment Incentives: A Theory Explaining the Use of Economic Value Added as a Performance Measure," Journal of Political Economy, University of Chicago Press, vol. 105(4), pages 770-95, August.
    14. Joseph G. Haubrich, 1991. "Risk aversion, performance pay, and the principal-agent problem," Working Paper 9118, Federal Reserve Bank of Cleveland.
    15. 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.
    16. Wallace, James S., 1997. "Adopting residual income-based compensation plans: Do you get what you pay for?," Journal of Accounting and Economics, Elsevier, vol. 24(3), pages 275-300, December.
    17. 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.
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