venanzi performance

Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209

Daniela Venanzi - Financial performance measures and value creation: a review working paper – december 27, 2010

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Financial performance measures and value creation: a review di

Daniela Venanzi

Full Professor of Corporate Finance Department of Business & Law – Roma Tre University

December 27, 2010

Contents 1. Introduction 2. Criticisms of the accounting-based measures of performance 3. Competing financial performance measures

3.1. Trends in performance measurement 3.2. Economic value measures

− Economic value added (EVA) − Cash flow return on investment (CFROI) − Shareholder value added (SVA)

4. The metrics war 4.1. The association between economic value measures and stock returns 4.2. The association between economic value measures and DCF approach 4.3. Managerial implications of economic value measures

5. A comparison: strengths and weaknesses of the economic value measures References

Abstract Corporate financial performance measured in terms of accounting-based ratios has been viewed as inadequate as firms began focusing on shareholder value as the primary long-term objective of the organization. Corporate managers have been facing a period where a new economic framework that better reflects economic value and profitability had to be implemented in their companies. The increased efficiency at the capital markets requires that capital allocation within companies become more efficient: a value based management framework that better reflects opportunities and pitfalls, is therefore necessary. Subsequently, value metrics were devised that explicitly acknowledged that both equity and debt have costs, and thus there was a need to incorporate financing risk-return into performance calculations. The focus of this article is a review of the main value-based measures: the economic value added (EVA), the cash flow return on investment (CFROI) and the shareholder value added (SVA). The objective is contributing to the developing dialogue on the appropriateness of different financial performance measures by reviewing their differences as well as their similarities in terms of measurement, association with market financial performance and DCF approach, implications on managerial incentives, and by highlighting their respective strengths and weaknesses.

Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209Electronic copy available at: http://ssrn.com/abstract=1716209


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1. INTRODUCTION

Periodic measurement of firm performance is conducted for several reasons: it helps investors to formulate their expectations concerning the future earning potential of firms; it supplies a plausible feedback on how well the company has achieved its goals; it furnishes the basis of an adequate bonus plan that gives incentives to achieve the firm’s goals and rewards the results of proper decisions. Corporate financial performance measured in terms of accounting‐based metrics has been viewed as inadequate as firms began focusing on shareholder value as the primary long‐term objective of the organization: they fail to take into account the factors that drive shareholder value. Subsequently, financial‐based value measures and value metrics were devised that explicitly acknowledged that both equity and debt have costs, and thus there was a need to incorporate financing risk‐return into performance calculations. The focus of this article is a review of the main value‐based measures: the economic value added (EVA) described by Stewart (1991), the cash flow return on investment (CFROI) approach of the Boston Consulting Group and the shareholder value approach (SVA) described by Alfred Rappaport (1986). Information and empirical results about the efficacy of the different approaches are limited and contradictory and seem to be primarily provided by authors with strong commercial interest in the outcome of any reasearch into the effectiveness of the methodologies. This paper aims at contributing to the developing dialogue on the appropriateness of different financial performance measures, with respect to their association with stock returns or DCF approach and their implications on managerial incentives and compensation. It would be a mistake to believe that any single measure is perfectly suited to all types of financial decision support, meanwhile it could be very useful to compare the different measures by highlighting their respective strengths and weaknesses as well as their similarities. This paper is organized as follows. First, we summarize the shortcomings of the accounting‐based measures of performance; therefore, we illustrate the economic measures, highlighting their differences in calculation. Subsequently, we compare the economic measures’ effectiveness by reviewing firstly the empirical evidence on their association with market measures of return; secondly, their linkage with DCF approach and finally their impact on management behaviour when used in compensation system. A final review of the strengths and weaknesses of each value‐based metrics will conclude the analysis.

2. CRITICISMS OF THE ACCOUNTING‐BASED MEASURES OF PERFORMANCE

Value is a function of 1) investments 2) cash flow 3) economic life and 4) capital cost. The mechanism that is used on the market to establish value using these four factors is what we call the Discounted Cash Flow (DCF) approach. This is the reason why we use DCF methods when we calculate on investments that we plan to make in a company. The objective for doing this is to be able to establish and execute strategies and investments that increase shareholder value. But in practice something peculiar seems to occur (Weissenrieder, 1997). After the investment has been made companies, analysts and media abandon this thinking and enter the world of P/E‐ratios, profit per share, ROI, balance sheets, P&L statements, book equity, goodwill, depreciation methods… We try to follow up the value creation and profitability of investments that we have made by using accounting data. Rappaport (2005) call this disease the short‐term earnings obsession. Accounting does not handle any of four factors the way a financial framework should handle them. What kind of information does the organization need for strategic decision making and for managing the company's current operations? Choosing something for the only reason that it looks much like what we see today from our current framework (accounting) would be a mistake. Compelling evidence indicates that managers are obsessed with earnings. A recent survey of 400 financial executives shows that the vast majority view earnings as the most important performance measure they report to outsiders (Graham et al., 2005). The two key earnings benchmarks are quarterly earnings for the same quarter last year and the analyst consensus estimate for the current quarter. Executives believe that meeting earnings expectations helps maintain or increase the stock price, provides assurance to customers


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and suppliers, and boosts the reputation of the management team. Failure to meet earnings targets is seen as a sign of managerial weakness and, if repeated, can lead to a career‐threatening dismissal. Managing for short‐term earnings compromises shareholder value. In the following section some fundamental shortcomings of the traditional accounting‐based metrics both as value measure and performance measure are summarized. a) inaccuracy and subjectivity of the accounting numbers The accounting principles provide companies with room to manipulate the accounting figures. Earnings number may be computed using alternative and equally acceptable accounting methods: a change in accounting method for financial reporting purposes can materially impact earnings but does not alter the company’s cash flows and therefore should not affect its economic value. This could produce two implications: − comparisons among different firms as well as different years of the same company are not reliable − managers can assume moral hazard behaviours that can induce various manipulations of accounting

data. A 2005 survey of 400 USA financial executives (Graham et al., 2005) reveals that companies manage earnings with more than just accounting gimmicks: a startling 80% of respondents said they would decrease value‐creating spending on research and development, advertising, maintenance, and hiring in order to meet earnings benchmarks. More than half the executives would delay a new project even if it entailed sacrificing value. Managers push revenues into the current period and defer expenses to future periods: they borrow from the future to satisfy today earnings expectations. Jensen (2004) cited WorldCom, Enron Corporation, Nortel Networks, and eToys as companies that pushed earnings management beyond acceptable limits to meet expectations and ended up destroying part or all of their value. As well as Jensen, we could cite Cirio and Parmalat as similar examples.

Moreover, accounting numbers can be distorted by inflation: in determining traditional accounting measures of return, both numerator and denominator of the accounting ratios add up not homogeneous numbers, i.e. numbers not expressed in the same monetary unit. For example, inflation can increase ROI by increasing capital turnover (sales are in current numbers, meanwhile invested capital is not). On the contrary, measures based on DCF calculations are not affected by inflation: in determining value‐based measures of performance it is enough to use homogeneous numbers (real or nominal) of cash flows and discount rates. Therefore ROI could depend on the average age of the fixed assets of the firm. Despite, International Financial Reporting Standards (IFRS) attempting to reduce the possibility of such manipulations, valuation methodologies such as “mark‐to‐market” tend to exacerbate the problem. b) nonalignment with the organizational goal of maximizing shareholder wealth Accounting‐based measures of return omit to consider the cost of invested capital, both in terms of risk‐free rate and risk premium. Therefore, maximizing earnings or return does no imply to maximize shareholder value. Maximizing earnings omit to account for the amount of capital invested to produce earnings. It could result convenient any investment that produce earnings, no matter what return it earns or what risk it bears. This case being true, a company always prefers to retain and reinvest its earnings, never to pay them out to investors. Instead, it could be demonstrate that cutting the firm’s dividends to increase investment will raise the stock price if, and only if, the new investment earns a rate of return on new investments greater than its cost of capital, i.e. the rate investors can expect to earn by investing in alternative, equally risky, securities. When we use accounting rates of return like ROI or ROA, we risk to incur in the same problem. To illustrate, a manager that uses ROI in its investment decisions will be encouraged only to select projects that equal or exceed his/her SBU’s or division’s current ROI regardless of the value creation of that investment in the longer term: projects of the same SBU or division can differ in risk and cost of capital from the average risk


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and cost of capital of the mix of assets in place. Obviously these measures encourage managers much more to act in ways that are incongruent with the corporate objective of maximizing shareholder wealth when managers are measured and rewarded on maximizing them. In marketing terms, it is imperative for businesses to allocate capital to endeavours that would be classified as “stars” in the Boston Consulting Group (BCG) matrix, and put to sleep those that would be classified as “dogs”. Traditional accounting performance measures may not enable management to identify between these and in fact may encourage dogs to be fed more. In order to avoid these misleading behaviors, hurdle rates or minimum acceptable rates for ROI are often based on an estimate of the business unit’s (or division’s) cost of capital. The essential problem with this approach is that ROI is an accrual accounting return and is being compared to a cost of capital measure which is an economic return demanded by investors. We can demonstrate that accounting return of investment differs from economic return of investment as well as apples differ from oranges (the case of a single project can be extended easily to many projects):

ACCOUNTING ONE‐YEAR RETURN: (cash flow – depreciation – other non cash charges + capital expenditures + incremental investments in working capital)/ average (over the year) net book value (i.e. book value minus accumulated depreciation);

ECONOMIC ONE‐YEAR RETURN = (cash flow + change in present value)/ investment present value at beginning of year. We can define the change of the present value over the year as economic depreciation. The economic return (r) can be derived as follows (CFt and VAt are cash flow and present value in year t , respectively):

1 1

1

∆

Note that unlike economic income that depends strictly on cash flows, book income (the numerator of the accounting return) departs from cash flow since it does not incorporate current year’s investment outlays for working capital or fixed capital. In addition, non cash items such as depreciation and provisions for deferred costs or losses are deducted to arrive at book income. Furthermore, depreciation represents the allocation of cost over the expected economic life of an asset. Accountants do not attempt nor do they claim to estimate changes in present value. If depreciation and the change in present value differ, then book income will not be an accurate measure of economic income. Therefore, ROI is not an accurate or reliable estimate of the DCF return. Solomon (1967) demonstrates that the extent to which ROI overstates the economic or DCF return is a complex function of the following factors (in parentheses the sign of the effect on the overstatement):

length of project life (+) capitalization policy (−) the speed of depreciation policy (+) the time lag between outlays and the recoupment of these outlays from cash inflows (+) the growth rate of new investments (−): if a company grows rapidly, its mix will be more heavily weighted with new investments for which ROIs will be relatively low. Thus, the ROI of a growth company will be lower than that a steady‐state one, investments’ economic returns being equal. When growth rate and economic rate of return are equal, ROI is equal too. ROI differs from economic return when the growth rate is greater or smaller than the economic return.


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He found also that there is no systematic pattern in the error that allows a correction to be made. The following example (Tables 1 and 2), referring to an investment in a new restaurant, shows that while the restaurant investment is expected to yield an economic return of 15%, the ROI results are substantially different. ROI progresses from a negative figure in the first year to 200% in the fifth year when the restaurant facilities are almost fully depreciated. Thus, ROI understates the economic rate of return in the first two years and significantly overstates it for the last three years. The five‐year average ROI is approximately 23%, almost twice the 15% DCF rate of return. As the above example illustrates, accounting ROI typically understates rates of return during the early stage of an investment and overstates rates in later stages as the asset base continues to decrease. Some might oppose that these errors offset one other over time as the firm moves toward a balanced mix of old and new investments. Unfortunately, the errors are not offsetting. Table 3 illustrates this problem. One restaurant (identical to the investment discusses earlier) per year is opened during the first five years. Thus, beginning in the fifth year the firm will find itself in a steady‐state situation. The steady‐state ROI is 23%, which significantly overstates the 15% economic rate of return. In addition to theoretical arguments, also empirical evidence shows that the accounting information does not by itself adequately explain market valuations nor provide comparability between firms, thus accounting data are inadequate in reliably capturing a firm’s true economic performance. Empirical data from many countries demonstrates the following evidence:

non apparent relationship between EPS growth and total shareholder returns weak correlation between EPS growth and price/earnings ratio (P/Es) robust correlation between market value and present value of expected cash flows statistically significant abnormal returns are observed when firms change accounting approach to valuing inventories and computing cost of sales: positive in shift from FIFO to LIFO and negative in the opposite shift. Therefore, if the inflation rate is non null, market returns result to be influenced by change in expected cash flows while do not react to change in accounting methods: the shift from FIFO to LIFO, in fact, if inflation rate is positive, lessen the accounting income and, all being equal, cash flows increase by means of smaller tax‐payments

greater correlation with market value added (market value of a company minus book value of its equity and debt) of DCF performance measures than accounting measures

greater correlation with market value added of residual income measures of performance, i.e. measures that account for the cost of capital invested.

Table 1 – The economic return of investing in a new restaurant

source: Rappaport (1986)

YEARS (data in ‘000€)

1 2 3 4 5

Cash flows 176,23 250 350 400 400

Present value (15%) (at beginning of year) (1)

1000 973,76 869,8 650,28 347,84

Present value (15%) (at end of year)

973,76 869,8 650,28 347,84 0

Change in value during year (economic depreciation)

‐ 26,24 ‐103,95 ‐219,52 ‐302,44 ‐347,84

Economic income 150 146 130,5 97,6 52,2

Economic rate of return (%) (2) 15 15 15 15 15

(1) The present value at the beginning of the year is calculated by discounting the remaining cash flows at 15% (2) Economic rate of return corresponds to IRR


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Table 2 – The ROI of investing in a new restaurant

source: Rappaport (1986) Table 3 –ROI in the steady‐state

c) short term‐ism of managerial decision‐making

Accounting measures of performance can orientate management to a mistaken concern about maximizing current performance measures. For example a manager that is measured on maximizing ROI will be encouraged only to select projects that equal or exceed their current ROI regardless of the potential value of investments in the longer term. Thus, the objective of maximizing ROI may result in projects that will create wealth for shareholder not to be approved. Managers can maximize current profits by reducing discretionary expenses that may adversely affect future profitability, by lessening future revenues (for example R&D expenses or other similar expenses like training and development costs, brand marketing expenses, advertising, etc.) or increasing future costs (for example plant and machinery maintenance costs). These investments are characterized by taking a long time to translate initial outflows into financial results, and as is stated in most strategy textbooks, long term survival of a firm is dependent indeed on this kind of investments. In addition, ROI does not account for the post‐planning period residual value of the business unit or company. Normally, only a small portion of a firm’s market value depends on profits generated in a five‐year span; conversely, the larger portion depends on cash flows generated beyond that point. A business

1 2 3 4 5 (steady‐state)

)

Accounting income (per restaurant)

1 ‐ 23,77 +50 +150 +200 +200 ‐ 2 ‐23,77 +50 +150 +200 +200 3 ‐23,77 +50 +150 +200 4 ‐23,77 +50 +150 5 ‐23,77 +50 6 ‐23,77

Accounting income (total) ‐ 23,77 26,23 176,23 376,23 576,23 576,23 Net book value (per restaurant)

1 900 700 500 300 100 ‐ 2 900 700 500 300 100 3 900 700 500 300 4 900 700 500 5 900 700 6 900

Net book value (total) 900 1600

2100 2400 2500 2500

ROI for all restaurants (%) ‐ 2,6 ‐1,6 8,4 15,7 23,0 23,0

YEARS (data in ‘000 €) 1 2 3 4 5

Cash flows 176,23 250 350 400 400

Depreciation (stright‐line)

200 200 200 200 200

Accounting income ‐ 23,77 50 150 200 200

Net book value (at beginning of year)

1000 800 600 400 200

Net book value (at end of year)

800 600 400 200

0

Average book value ROI (%)

900 ‐2,6

700 7,1

500 30

300 66,7

100 200


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attempting to increase its market share and competitive position will likely increase its new product development and marketing spending, price aggressively, and invest in expanded production capacity and working capital (Rappaport 1986). While these activities will strengthen the organization long term strategic position and increase market value, ROI is likely decline over the next several years. Conversely, a harvesting strategy allows erosion in market share and will generate better planning‐period ROIs, but the residual value is likely to be very small.

3. COMPETING FINANCIAL PERFORMANCE MEASURES

3.1 Trends in performance measurement The choice of performance measures is one of the most critical challenges facing organizations. Performance measurement systems play a key role in developing strategic plans, evaluating the achievement of organizational objectives and compensating managers. Many managers feel that traditional accounting‐based measurement systems no longer adequately fulfil these functions. A 1996 survey by the Institute of Management Accounting (IMA) found that only 15 percent of the respondents' measurement systems supported top management's business objectives well, while 43 percent were less than adequate or poor. In response, firms increasingly are implementing new performance measurement systems to overcome these limitations. Sixty percent of the IMA respondents, for example, reported they were undertaking a major overhaul or planning to replace their performance measurement systems. The perceived inadequacies in traditional accounting‐based performance measures have motivated a variety of performance measurement innovations ranging from "improved" financial metrics such as "economic value" measures to "balanced scorecards" of integrated financial and nonfinancial measures (Ittner and Larcker, 1998). Most economic theories analyzing the choice of performance measures indicate that performance measurement and reward systems should incorporate any financial or nonfinancial measure that provides incremental information on managerial effort (subject to its cost). Despite these models, firms traditionally have relied almost exclusively on financial measures such as budgets, profits, accounting returns and stock returns for measuring performance (Ittner and Larcker, 1998). Table 4 – Uses, quality and perceived importance of financial and non financial performance measures –

(Lingle and Schiemann, 1996)

source: Ittner and Larcker (1998)

Schiemann and Associates surveyed 203 executives in 1996 on the quality, uses and perceived importance of various financial and nonfinancial performance measures (Lingle and Schiemann, 1996). Their results are presented in Table 4. While 82 percent of the respondents valued financial information highly, more than


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90 percent clearly defined financial measures in each performance area, included these measures in regular management reviews, and linked compensation to financial performance. In contrast, 85 percent valued customer satisfaction information highly, but only 76 percent included satisfaction measures in management reviews, just 48 percent clearly defined customer satisfaction for each performance area or used these measures for driving organizational change, and only 37 percent linked compensation to customer satisfaction. Similar disparities exist for measures of operating efficiency, employee performance, community and environment, and innovation and change. More importantly, most executives had little confidence in any of their measures, with only 61 percent willing to bet their jobs on the quality of their financial performance information and only 41 percent on the quality of operating efficiency indicators, the highest rated nonfinancial measure (Ittner and Larcker, 1998). Perceived inadequacies in traditional performance measurement systems as well as the managers’ confidence in financial performance have led many organizations to place greater emphasis on "improved" financial measures that are claimed to overcome some of the limitations of traditional financial performance. We review this trend in the following section.

3.2 Economic value measures

While traditional accounting measures such as earnings per share and return on investment are the most common performance measures, they have been criticized for not taking into consideration the cost of capital and for being unduly influenced by external reporting rules. Meanwhile the traditional discounted cash flow (DCF) model provides for a thorough analysis of all of the different ways in which a firm can increase value, it can become complex, as the number of inputs increases. It is also very difficult to tie management compensation systems to a discounted cash flow model, since many of the inputs need to be estimated and can be manipulated to yield the results that one wants. Instead of explicit DCF model a simplified formula‐based DCF approach can be used by making simplifying assumptions about a business and its cash flow stream (for example, constant revenue growth and margins) so that the entire DCF can be captured in a concise formula (Copeland et al., 1990). The Miller‐Modigliani (MM) formula (Table 5), while simple, is an example that is particularly useful for demonstrating the sources of a company’s value. The MM formula values a company as the sum of the value of the cash flow of its assets currently in place plus the value of its growth opportunities; because the formula is based on sound economic analysis, it can be used to illustrate the key factors that will affect the value of the company and therefore to show how the two components of value performance can be measured separately, although it is likely to be too simple for real problem solving, unfortunately. In addition, it was stated that NPV concept is useless unless we can discount the investment’s complete cash flow over its completed economic life: in other words, it is only when it is considered over the life of the business, and not in any given year, that cash flow approach becomes significant. Thus, it could be a measure of performance only if it could be periodized into years, quarters, months or the time period of the user’s choice. Moreover, this is what some “new economic measures” (which will be analyzed below) try to do. If we assume that markets are efficient, we can replace the unobservable value from the discounted cash flow model with the observed market price, and reward or punish managers based upon the performance of the stock. Thus, a firm whose stock price has gone up is viewed as having created value, while one whose stock price goes down has destroyed value. Compensation systems based upon the stock price, including stock grants and warrants, have become a standard component of most management compensation packages. While market prices have the advantage of being updated and observable, they are also noisy. Even if markets are efficient, stock prices tend to fluctuate around the true value, and markets sometimes


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do make big mistakes. Further, a firm’s stock performance seems to be much more reliable when evaluated over several years. Thus, a firm may see its stock price go up, and its top management rewarded, even as it destroys value. Conversely, the managers of a firm may be penalized as its stock price drops, even though the managers may have taken actions that increase firm value. In addition, market measures of performance reflect factors beyond managers’ control (such as declining inflation and lower interest rates, for example) as well as tend to aggregate relevant information inefficiently for compensation purposes (their forward‐looking character may result in compensating for promises and not for actual achievements); finally, they cannot be disaggregated beyond the firm level. Thus, they cannot be used to analyze the managers of individual divisions of a firm, and their relative performance. Consulting firms promoted a variety of "economic value" measures to overcome limitations of accounting‐based and market measures. We illustrate in this section the most known metrics. Table 5 – The Miller‐Modigliani DCF formula (Miller‐Modigliani, 1961) value of entity = value of assets in place + value of growth

value of assets in place =

value of growth =

where: E(NOPAT)= expected net operating profit after taxes (assumed as proxy of expected cash flows after taxes) WACC = weighted average cost of capital after taxes K = investment rate (percentage of cash flows invested in new projects) r = rate of return on invested capital N = interval of competitive advantage The foundation for all these "new" performance measures is the concept of residual income (RI), developed many years ago indeed (Worthington et al., 2001). In the 1920 seminal contribution, Marshall concluded, “the gross earnings of management which a man is getting can only be found after making up a careful account of the true profits of his business, and deducting interest on his capital”. Later, the desirability of quantifying economic profit as a measure of wealth creation was operationalized by Solomons (1965) “as the difference between two quantities, net earnings and the cost of capital”. As early as the 1920’s General Motors applied this concept and in the 1950’s General Electric labelled it “residual income” and applied it as a performance measure to their decentralized divisions. It is defined in terms of after‐tax operating profits less a charge for invested capital, which reflects the firm’s weighted average cost of capital. Close parallels are thereby found in the related (non‐trademarked) concepts of abnormal earnings, excess earnings, excess income, excess realisable profits and super profits (Biddle et al., 1997). Economic profit (EP) is a variant of RI but as a return of equity. It is the book profit less the equity’s book value (at the beginning of the considered period) multiplied by the required return to equity. As ROE is the ratio of profit after taxes to book value of equity, we can also express the economic profit as

, where is the beginning book value of equity and is the cost of equity. It is obvious that for the equity market value to be higher than its book value, ROE must be greater than , if ROE and are constant (Fernandez, 2003).


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Economic value added (EVA) Stern Stewart & Co.'s (hereafter Stern Stewart) trademarked "Economic Value Added" (EVA) is the firm's proprietary adaptation of residual income. EVA is a modified version of residual income where the modifications consist of accounting adjustments designed to convert accounting income and accounting capital to economic income and economic capital. Thus, the significance of the difference between EVA and residual income is dependent upon the impact of these accounting adjustments. EVA is determined as adjusted operating income minus a capital charge, and assumes that a manager's actions only add economic value when the resulting profits exceed the cost of capital.

Economic Value Added = NOPAT – cost of capital x capital invested = (ROC– cost of capital) x (capital invested)

where NOPAT = net operating profit after taxes ROC = NOPAT/capital invested = return on capital (invested). There are three basic inputs that we need for EVA computation: the return on capital earned on an investment, the cost of capital for that investment and the capital invested in it. There are two ways of estimating NOPAT (Damodaran, 2000). One is to use the reported EBIT on the income statement and to adjust this number for taxes: NOPAT = EBIT (1‐ tax rate). When we use this computation, we ignore the tax benefit of interest expenses since it is already incorporated into the cost of capital (by an after‐tax cost of debt). Alternatively, we can arrive at NOPAT by starting with net income as follows: NOPAT = net income + interest expenses (1‐ tax rate) – non‐operating income (1‐tax rate). Adding back the after‐tax portion of interest expenses ensures that the tax benefit from debt does not get double counted. It is more difficult to estimate the capital invested at the level of the firm than of a single project, because in a firm projects tend to be aggregated and expenses are allocated across them. One obvious solution may be to use the market value of the firm, but market value includes capital invested not just in assets in place but in expected future growth. If we want to evaluate the quality of assets in place, we need a measure of the market value of just these assets. Given the difficulty of estimating market value of assets in place, many analysts turn to the book value of capital as a proxy for the market value of capital invested in assets in place (Damodaran, 2000). We can use a double approach to measure invested capital. The capital‐based approach considers the book values of equity and interest bearing debt (netted against cash balances). The asset‐based approach could arrive at a similar result using the book values of the assets of the firm as follows: invested capital = net fixed asset + current asset ‐ current liabilities ‐ cash = net fixed asset + non‐cash working capital. The two approaches could give non‐equivalent results when the firm has long‐term liabilities that are not interest bearing debt (for example provisions and similar): they will be excluded from the invested capital computation when we use the capital approach. The reason we net out cash is consistent with the use of operating income as our measure of earnings. The interest income from cash or cash equivalents is not part of operating income. Obviously, for companies with significant cash balances, exclusion of cash from invested capital and of its interest income from NOPAT could discourages managers to use cash balances efficiently. The book value, however, is a number that reflects not just the accounting choices made in the current period, but also accounting decisions made over time on how to depreciate assets, value inventory and deal with acquisitions (Damodaran, 2000). It is also influenced by the accounting classification of expenses


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into operating and capital expenditures, with only the latter showing up as part of capital. The limitations of book value as a measure of capital invested has led analysts who use EVA to adjust the book value of capital to get a better measure of capital invested. Similar problems arise when we need to estimate NOPAT and ROC. The operating income that we would like to estimate would be the operating income made by assets in place. The operating income, usually measured as earnings before interest and taxes in an income statement, may not be a good measure of this figure, for the same reasons that has led to adjust the book value of capital invested. The practitioners who use EVA claim to make many adjustments to the accounting measures of both operating income and invested capital. Stern Stewart makes as many as 164 adjustments to arrive at EVA. Table 6 summarizes some of the adjustments recommended by Stern Stewart (Stewart, 1991) for converting from book value and book NOPAT to what it calls economic book value and economic NOPAT respectively (Fernandez 2002). Table 6 – Adjustments suggested by Stern Stewart for calculating the EVA

Some of these adjustments include (Damodaran, 2000): − capitalizing any operating expense that is intended to create income not in the current period , but in

future periods. An example is research and development expenses (other examples are training and development costs, brand marketing expenses, advertising, etc.), which accounting standards require be expensed, but which clearly are intended to generate future growth. The standard treatment is to capitalize research and development expenses and augment the capital invested by this amount (accrued R&D expenses netted against cumulative amortization). Correspondingly, the operating income should be considered without these expenses, while the amortization of these capitalized expenses must be yearly deducted from NOPAT. Making this adjustment for high‐technology firms will drastically alter their return on capital, reducing it in most cases considerably. Once you have


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capitalized R&D, any new R&D increases this asset, but existing R&D will be amortized over time, reducing it. The rate at which the R&D is amortized will be sector‐specific and reflect the rate at which the benefits of new R&D decay in the sector;

− capitalizing any operating expenses that are really financing expenses in disguises. The most common illustration of this is operating lease expenses, which reduce operating income in the period in which they are paid. This is in contrast to the treatment of capital leases, where firms are required to compute the present value of lease obligations and treat it as debt. From a financial standpoint, there is little difference between operating and capital leases. Therefore, it does make sense to compute the present value of operating lease commitments and treat them as debt, thus increasing capital invested. A similar adjustment regards pension provisions: they should be included in computing capital invested as if they were equivalent to debt and their financial costs (for example, in Italy TFR costs per year are equal to 1,5% + 75% of inflation rate) should be added back to NOPAT;

− eliminating any items that may cause the book value of capital to drop without really impacting capital

invested. Here, we have to consider the amortization of goodwill, that reduces the book value of capital but does not reduce capital invested and should be added back (but only the part of goodwill referred to asset in place – measured as difference between the acquisition price and the market value prior to acquisition – should be included in invested capital); earnings prior to the amortization of goodwill should be considered, correspondingly. Similar adjustments regard allowances for bad debts, stock obsolescence and similar ones; they should be assimilated to equity reserves and then computed in calculating the capital invested; correspondingly changes (net of taxes) in these allowances (changes are equal to provisions less utilizations in the current year) should be added back to NOPAT (in this way NOPAT is affected only by cash utilizations of this allowances, i.e. when the losses or the minor inflows occur). A similar adjustment regards the LIFO reserve. The LIFO reserve is the difference between the accounting cost of an inventory that is calculated using the FIFO method, and one using the LIFO method. In the typical inflationary environment, the value of a FIFO inventory is higher than the value of a LIFO inventory, so the calculation of the LIFO reserve is : LIFO reserve = FIFO valuation ‐ LIFO valuation. Since the reason for valuing an inventory using LIFO is usually to defer the payment of income taxes, the LIFO reserve essentially represents the amount by which an entity's taxable income has been deferred by using the LIFO method. Reserve should be added to invested capital and year‐to‐year increase to be added back to NOPAT. Similar examples are the one‐time restructuring charges which result in a large negative operating income when we account for extraordinary losses and declines in book value of capital. Losses from sales of assets should be added back to invested capital and NOPAT as well as gains should be subtracted. Similar adjustments regard stock buybacks. They have a disproportionate impact on book value of capital when market value is well in excess of book value: in fact the book value of equity is reduced by the market value of the buyback; if the price to book ratio is for example of 10, a buyback of 5% reduces the book value of equity by 50%;

− adjusting for any actions that should have caused book value of capital but did not because of accounting treatment. For example when pooling is used to account for a merger (the book value remains in the balance sheet – the balance sheet thus looks smaller – and the goodwill is ignored, i.e. it is treated in the same way as internally generated goodwill), the book value of capital is usually corrected, by augmenting it to reflect the price paid on the acquisition and the premium over book value. It should be noted that the proportion of premium paid for expected future growth potential in the acquired firm should not added on to arrive at capital invested.


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It should be noted the impact on tax charge of making the adjustments above. For example, if we add back to NOPAT the R&D costs previously expensed, we implicitly include the tax shield of these expenses in the NOPAT calculations; conversely, if we add back the R&D expenses after taxes (i.e. the gross amount multiplied by (1‐ tax rate) ), then we ignore it. Moreover, if we add back to NOPAT the R&D expenses minus the year amortization of the capitalized R&D expenses, both after taxes, therefore we are only considering the tax shield associated with the amortization. The above are only some of the suggested adjustments. Young and O’Byrne (2001) admit that “....even the most ardent EVA advocate would concede that no company should make more than, say, 15 adjustments”. They further state that 10‐12 accounting adjustments were most common but that number has now declined to five or fewer and in some case no adjustments are made. The explanation they give for this reduction is: a) managers are reluctant to deviate from GAAP‐based numbers; b) companies have found that most of the suggested adjustments have little impact on profit and capital. Moreover, external analysts who choose to use EVA have to accept the reality that their estimates of operating income can adjust only for the variables on which there is public information. Anderson et al. (2005) found that, in a sample of 317 USA firms over a ten year time period, five accounting adjustments yielded on average an EVA only 7,1 % less than the EVA reported by Stern‐Stewart for the same firms and time period. The two accounting adjustments with the largest impact, R&D and LIFO reserve, accounted for 92% of the total change in EVA due to the five accounting adjustments. The inconsistency over time of the differences, both in absolute and percentage terms, between Stern‐Stewart’s EVA and Anderson et al.’s adjusted EVA does not support for the need for a large number of accounting adjustments. In addition, evidence shows a strong instability of EVA adjustments over time and a very strong relationship between adjusted and unadjusted EVA. Therefore, accounting adjustments for EVA seem to be much to do about nothing. The third and final component needed to estimate the economic value added is the cost of capital. A school of thought argues that the cost of capital should be estimated using book value weights for debt and equity, since the return on capital and capital invested are measured in book value terms. This argument does not really hold up, for the following reasons (Damodaran, 2000). First, it is not the book value of capital that we should really be measuring in capital invested, but the market value of assets in place. Therefore, it is clear that using a book value cost of capital essentially is equivalent to assuming that all debt is attributable to assets in place, and that all future growth comes from equity. Put another way, if we adopted this rationale in valuation, we would discount cash flows from assets in place at the book cost of capital, and all cash flows from expected future growth at the cost of equity. Second, using a book value cost of capital for all economic value added estimates, including the portion that comes from future growth, will destroy the basis of the approach, which is that maximizing the present value of economic value added over time is equivalent to maximizing firm value. Third, if changing capital structure is one tool that can be used to increase EVA, the mechanics work far better if market value cost of capital is used rather than book value. From a practical standpoint, using the book value cost of capital will tend to understate cost of capital for most firms, and will understate it more for more highly levered firms than for lightly levered firms. Understating the cost of capital will lead to overstating the EVA. Thus, rankings based on book value cost of capital are biased against firms with less leverage, and biased towards firms with high leverage. Cash flow return on investment (CFROI) A second economic value measure that has received considerable attention is "Cash Flow Return on Investment" (CFROI) and its variants (proposed by the Boston Consulting Group). CFROI essentially is a modified version of internal rate of return, designed for investments that have already been made. The CFROI for a firm is compared to the cost of capital to valuate whether a company’s investments are good, neutral or poor investments. To enhance its value then a firm should increase the spread between its CFROI and its cost of capital.


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The CFROI is calculated using four inputs (Damodaran, 2000). The first input is the gross investment (GI) that the firm has in its assets in place. This is computed by adding back depreciation to the net asset value to arrive at an estimate of the original investment in the asset. In addition, non‐debt liabilities (allowances) and intangibles such as goodwill are netted out. Finally, the gross investment is converted into a current dollar value to reflect inflation that has occurred since the asset was purchased. The second input is the gross cash flow (GCF) earned in the current year on that asset. This is usually defined as the sum of the after‐tax operating income of a firm and the non‐charges against earnings, such as depreciation and amortization. The operating income should be adjusted for operating leases and any accounting effects, much the same way that it was adjusted for to compute EVA (as well as GI). The third input is the expected life of the assets (n) in place, at the time of the original investment, which varies from sector to sector but reflects the earning life of the investments in question. The expected value of the assets (SV=salvage value) at the end of this life, in current dollars, is the final input. This is usually assumed to be the portion of the initial investment, such as land and buildings that is not depreciable, adjusted to current dollar terms (practitioners include also inflation‐adjusted current assets). The CFROI is the internal rate of return of these cash flows, i.e. the discount rate that makes the net present value of the gross cash flows and salvage value equal to the gross investment, and can thus be viewed as a composite internal rate of return, in current dollar terms. This is compared to the firm’s real cost of capital to evaluate whether assets in place are value creating or value destroying. The real cost of capital can be estimated using the real costs of debt and equity, and market value weights for debt and equity.

1

An alternative formulation of the CFROI allows for setting aside an annuity to cover the expected replacement cost of the asset at the end of the project life. This annuity is called the economic depreciation and is computed as follows:

1 1 ⁄

where n is the expected life of the asset and the expected replacement cost of the asset is defined in current dollar terms to be the difference between the gross investment and the salvage value. The CFROI for a firm or a division can then be written as follows:

CFROI Gross Cash Flow ‐ Economic Depreciation /Gross Investment Appendix shows the equivalence between two formulas, when we assume in deriving the economic depreciation a discount rate kc CFROI. The differences in discount rate assumptions account for the difference in CFROI estimated using the two methods. In the first formula the intermediate cash flows are discounted at the CFROI, while in the second, at least the portion of the cash flows that are set aside for replacement, get reinvested at the cost of capital. If net present value provides for the genesis for the EVA approach, the internal rate of return (IRR) is the basis for the CFROI approach. In investment analysis, the IRR on a project is computed using the initial investment on the project and all cash flows over the project’s life. The IRR calculation can be done entirely in nominal terms, in which case the internal rate of return is a nominal IRR and is compared to the nominal cost of capital, or in real terms, in which case it is a real IRR and is compared to the real cost of capital. At first sight, the CFROI seems to do the same thing. It uses the gross investment (in current dollars) in the project as the equivalent of the initial investment, assumes that the gross current‐dollar cash flow is maintained over the project life and computes a real internal rate of return. There are, however, some significant differences (Damodaran, 2000):


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• the IRR does not require the after‐tax cash flows to be constant over a project’s life, even in real terms,

meanwhile the CFROI approach assumes that real cash flows on assets do not increase over time. It should be noted, however, that the CFROI formula can be modified to allow for real growth

• the second difference is that the IRR on a project or asset is based upon incremental cash flows in the future. It does not consider cash flows that have occurred already, that are viewed as “sunk”. The CFROI, on the other hand, tries to reconstruct a project or asset, using both cash flows that have occurred already and cash flows that are yet to occur. More specifically, IRR is always forward looking while CFROI is not. The implications are relevant: a CFROI that exceeds the cost of capital is usually considered a sign that a firm is using its assets well, but that might not be true. If the IRR is less than the cost of capital, that interpretation is false.

From the CFROI we can derive the cash value added (CVA) by multiplying the spread between CFROI and WACC by the inflation‐adjusted cash investment. Shareholder value added (SVA) The third economic measure is the shareholder value added (SVA) elaborated by Rappaport (1986) and Alcar Consulting Group. The key‐factors in determining SVA are the following: − growth rate of sales − rate of operating profit margin (netted against depreciation) − (cash) tax rate − rate of incremental fixed capital investment, in terms of rate of capital intensity of sales, netted against

depreciation (depreciation is implicitly considered equal to replacement investment of fixed capital) − rate of incremental working capital investment (in terms of rate of working capital intensity of sales) − cost of capital, expressed in terms of weighted average cost of capital (WACC) − value growth duration (planning period or competitive advantage period). It corresponds to the length

of time that the firm is expected to earn returns in excess of its cost of capital. It depends on how company’s strategies are more or less quickly emulated by potential competitors.

These variables are combined in the following model (consistent with DCF approach) in order to measure the value creation of a strategy (valid both in backward and forward looking valuation):

value created by strategy change of shareholder value generated by strategy with respect to non‐strategy scenario

shareholder value gross corporate value – market value of debt and other obligations

gross corporate value present value of operating cash flows during the forecast period terminal

value at the end of the forecast period cash & cash equivalents and non‐operating assets whose returns are excluded from operating CF

operating cash flowt salest‐1 x 1 growth rate of sales x rate of operating profit margin x 1‐ tax

rate – salest – salest‐1 x rate of incremental investment in fixed assets and working capital. Cash flows and terminal value are discounted by the cost of capital. The terminal value at the end of the forecast period can account for a great part of a company’s (or business unit’s) market value, depending on growth or harvesting strategies adopted. Terminal value can be determined by using different approaches in different situations. It can be estimated as a “break up” value (when the firm ceases operations at the end of the forecast period) or as a perpetuity of the net operating cash flow at the horizon, assuming a steady‐state beyond this term or a constant rate of growth continuing indefinitely. Sometimes multiple approach could be used. We observe that assuming a constant operating cash flow beyond the end of the forecast period does not imply a non‐growth state of the


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business, but that future new investments’ rate of return is equal to their cost of capital; thus, incremental cash flows can be ignored in calculating the value of business.

4. THE METRICS WAR Considerable debate exists on the relative value relevance of the alternative economic value measures. Consulting firms battle over the superiority of their economic value measures, charging that competitors' measures have flaws that compromise their predictive ability. A number of impressive claims have been made for each of the economic value measures. Stern Stewart, for example, cites in‐house research indicating that "EVA stands well out from the crowd as the single best measure of wealth creation on a contemporaneous basis" (Stewart, 1991), while Dixon and Hedley (1993) of Braxton Associates cite an internal study showing their CFROI measure explains 91 percent of the variation in market capitalization ratios. Advocates of CFROI argue that this metric is vastly superior to traditional accounting measures and EVA as a performance measure. In an article on the "metric wars" between consulting firms pushing various economic value measures, a partner at HOLT Value Associates claimed "CFROIs are ideally suited to displaying long‐term track records, whereas a Stern Stewart‐type EVA is in millions of dollars, heavily influenced by asset size, and unadjusted for inflation‐induced biases" (Myers, 1996). Responded Stern Stewart co‐founder G. Bennet Stewart III "CFROI is literally a consultant's concoction. It was quite an imaginative development by a consulting firm, but it is not well grounded in the basic elements of corporate finance theory. CFROI attempts to measure shareholder wealth—which is not clearly related to maximizing shareholder wealth" (Myers, 1996). Claims such as these have caused a growing number of firms to adopt various forms of economic value measures. A 1996 survey by the Institute of Management Accountants (IMA, 1996) found that 35 percent of the respondents used EVA or similar measures (up from 18 percent in 1995) and 45 percent expected to use them in the future (up from 27 percent in 1995). Yet, despite the increasing emphasis on these measures, research on the extent to which they are superior to traditional accounting measures is limited and mixed. In the next paragraphs we will analyze the different perspectives to whose respect the various metrics’ effectiveness could be evaluated.

4.1 The association between economic value measures and stock returns Many empirical studies have investigated the correlation of the most known economic measures with excess returns, back‐testing them against the underlying companies’ actual wealth creation, as evidenced by subsequent stock price increases, or comparing them to market value added. Most studies to date have examined claims made by the proponents of each of these value‐based measures that their own measures were better predictors of stock returns than traditional accounting measures or rival firms’ measures. Since the avowed goal of the new performance measures is to increase shareholder wealth, the correlation of such measures with stock returns has an obvious appeal. However a strong statistical correlation with stock returns does not establish that a performance measure adds value. No measure of performance could ever have a higher statistical correlation with stock returns that the return itself. Thus, if correlation were the only goal, firms should solely use their stock price for compensation and ignore all other measures. However, as argued above, stock returns can be a noisy and even a misleading measure of managers' value added. Therefore, the rationale is that any financial measure used in assessing firm’s performance must be highly correlated with shareholders wealth and on the other hand should not be subjected to randomness inherent in it. This research domain includes studies that empirically investigate the degree of correlation between different performance measures (accounting‐ and value‐based) and stock market returns and/or MVA and its changes. R2 and panel data regression model have been used to measure value relevance: in these regression models MVA (level or year‐to‐year change) or total shareholder returns are the dependent variables and the various performance measures are the explanatory variables. In some studies the


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dependent variable is expressed in terms of abnormal or unexpected returns and the competing performance measures (the independent variables) are measured in terms of levels and change specifications (Easton and Harris, 1991) or of forecast errors, as the difference between the realized value of a performance measure and the market’s expectation (Biddle et al., 1997). It is assumed that market expectations are formed according to a discrete linear stochastic process in function of lagged observations of the performance measure. In some studies the incremental information content of the economic measures is explored by introducing in the regression model the components in which the measure can be decomposed as explanatory variables; for example in Biddle et al. (1997) the EVA is decomposed in 5 parts: cash flow from operations, operating accruals, after‐tax interest expense, capital charge, and accounting adjustments. Researchers have employed two approaches, relative vs. incremental information content, to compare information usefulness of different measures. Relative information content compares which performance measure is superior in terms of association with stock returns, while incremental information content addresses whether one measure adds to the information provided by the other. The two information content types have different practical implications. With knowledge of relative information usefulness, one will be able to choose a single best performance measure among competing ones. On the other hand, incremental information usefulness will help one decide whether to employ multiple measures in financial reporting. Evidently, both are important considerations in the choice of performance measures. Frequently incremental approach is used adding economic measures to accounting measures in the regression model. The empirical evidence about the association between the economic metrics and market‐based performance measures is mixed and not definitive. Some studies reveal a stronger association of the economic measures than the traditional accounting counterparts; others report, conversely, that the last are better predictors of stock returns than the former. In addition, some studies are concentrated on a specific economic measure (mostly EVA) compared to more traditional metrics; others compare the relative explanatory content of a larger set of metrics. Many studies to date have examined claims that EVA is a better predictor of stock returns than traditional accounting measures. a) Milunovich and Tseui's (1996) examination of the computer server industry found market‐value added

between 1990 and 1995 more highly correlated with EVA than with earnings per share, earnings per share growth, return on equity, free cash flow, or free cash growth.

b) Lehn and Makhija (1997) also found that stock returns over a ten‐year period were more highly correlated with average EVA over the period than with average ROA, ROS, or ROE. In addition, EVA performed somewhat better than accounting profits in predicting CEO turnover.

c) O'Byrne (1996) examined the association between market value and two performance measures: EVA and net operating profit after tax (NOPAT). He found that both measures had similar explanatory power when no control variables were included in the regression models, but that a modified EVA model had greater explanatory power when indicator variables for 57 industries and the log of capital for each firm were included as additional explanatory variables. However, O'Byrne (1996) did not make similar adjustments to the NOPAT model, making it impossible to compare results using the different measures.

Other studies suggest that EVA is predictive of stock returns, but is not the only performance measure that ties directly to a stock's intrinsic value, one of the primary claims of EVA advocates (e.g. Stewart, 1991). a) Chen and Dodd (1997) examined the explanatory power of accounting measures (earnings per share,

ROA and ROE), residual income, and various EVA‐related measures. They found that EVA measures outperformed accounting earnings in explaining stock returns, but the associations were not as strong as suggested by EVA proponents (maximum R2 = 41.5 percent). In addition, accounting earnings provided significant incremental explanatory power above EVA, leading the authors to conclude that


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firms should not follow EVA advocates' prescription to replace traditional accounting measures completely with EVA. Finally, residual income provided nearly identical results to EVA, without the need for the accounting adjustments advocated by Stern Stewart.

b) Biddle et al. (1997) provide the most comprehensive study of EVA's value relevance to date. Their analyses examined the power of accounting measures (earnings and operating profits) to explain stock market returns relative to EVA and five components of EVA (cash flow from operations, operating accruals, after‐tax interest expense, capital charge, and accounting adjustments). They found that traditional accounting measures generally outperformed EVA in explaining stock prices. While capital charges and Stern Stewart's adjustments for accounting "distortions" had some incremental explanatory power over traditional accounting measures, the contribution from these variables was not economically significant. Sensitivity analyses indicated that these results were robust to Stern Stewart's grouping of firms into five "types" based on their past operating returns and growth rates, the time period examined, and the dependent variable used in the tests (i.e., stock returns or levels or the time frame used to compute the market measures).

c) Fernandez (2003) analyzed 582 American companies using EVA, MVA, NOPAT and WACC data provided by Stern Stewart. For each of the 582 companies, he calculated the 10‐year correlations between the increase in the MVA each year and each year’s EVA, NOPAT and WACC. For 296 (of the 582) companies, the correlation between the increase in the MVA each year and the NOPAT was greater than the correlation between the increase in the MVA each year and the EVA. The NOPAT is a purely accounting parameter, while the EVA seeks to be a more precise indicator of the increase in the MVA. There are 210 companies for which the correlation with the EVA has been negative. The average correlation between the increase in the MVA and EVA, NOPAT and WACC was 16%, 21% and –21.4%., respectively. The average correlation between the increase in the MVA and the increases of EVA, NOPAT and WACC was 18%, 22.5% and –4.1%. He also found that the correlation between the shareholder return in 1994‐1998 and the increase in the CVA (according to the Boston Consulting Group) of the world’s 100 most profitable companies was 1.7%.

Chari (2009) presents a review of empirical literature that evaluate the superiority of EVA over other traditional measures in terms of better association with shareholder returns. He finds that the empirical findings are mixed. Only 6 out of the total 10 studies examined (chosen by giving preference to differences in methodology, sample size and country of study) conclude that EVA is superior to other accounting measures; he attributes the inconsistency in the findings with respect to superiority of EVA to the methodology and impact of inflation. In fact, recent studies (Das et al., 2007) conclude that a non‐linear S shaped function better characterizes return‐earnings relationship; hence, the linear assumption can lead to the distortion of the findings in the researches conducted. In addition, discrepancy between accounting profits and true profits along with inflation distorts EVA (which is based on accounting profits). Clinton and Chen (1998) study followed a more comprehensive approach. They analyzed and evaluated EVA, CFROI and Residual Cash Flow (RCF = operating cash flow – cost of capital x beginning capital) in order to examine their correlation with stock prices and stock returns. Furthermore, other performance measurements analyzed include traditionally reported measures such as operating income and cash flow as well as the traditionally used ROI. The authors selected a sample of 325 firms from the Standard & Poor’s 500 and the Stern Stewart 1996 Performance 1000 databases, for the years 1991 to 1995. They consistently defined all items of the measurements in order to be comparable and then conducted the correlation analysis to stock prices and stock returns. While residual‐based measures have been heavily promoted as better choices than ROI‐based measures, all three residual‐based measures showed a lower association with stock values than their traditionally reported counterparts. Most of the RI and EVA correlations with stock prices or stock returns were either insignificant or of unexpected negative signs. Operating cash flow and adjusted operating income reported the best‐performing categories and have higher association to stock price and stock return compared to the others. Of the three new measurements, RCF is the only one that showed encouraging correlations. The more popular RI and ROI, and the most recently highly promoted EVA and CFROI produced either insignificant or inconsistent


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correlations and therefore indistinguishable in their relative lack of contribution to assessing firm value. The authors then suggest RCF as the best choice to use in linking profit to capital and ultimately to market value. RCF maintains the advantages of using a cash‐based and a residual‐based measure. The residual cash flow measure is consistent with capital asset investment planning and is already stated in terms of cash so adjustment to remove accounting distortions is not necessary. A preliminary conclusion is that the relative ability of different economic value measures to predict stock returns is unknown. If, as might be expected, one measure does not consistently exhibit superior predictability, researchers can attempt to determine the factors explaining cross‐sectional differences in the predictive ability of alternative economic value measures. Structural and environmental variables such as firm strategy, competitive environment, and product or industry life cycle, for example, are likely to be important determinants of the relative explanatory power of different economic value measures, as well as the explanatory power of traditional accounting measures (Ittner and Larcker, 1998). In addition, as Damodaran (2000) observed, we would not expect there to be any correlation between the magnitude of EVA and stock returns, or even between the change in EVA and stock returns. This is because the market value has built into it expectations of future EVAs. Whether a firm’s market value increases or decreases on the announcement of higher EVA will depend in large part on what the expected change in EVA was. For mature firms, where the market might have expected no increase or even a decrease in EVA, the announcement of an increase will be good news and cause the market value to increase. For firms that are perceived to have good growth opportunities and were expected to report an increase in EVA, the market value will decline if the announced increase in EVA does not measure up to expectations. This should be no surprise to investors who have recognized this phenomenon with EPS for decades; the earnings announcements of firms are judged against expectations, and the earnings surprise is what drives prices. The same apparent paradox can be noted about CFROI. There is a relationship between CFROI and market value, with firms with high CFROI generally having high market value. This is not surprising, and mirrors what we noted about EVA earlier. In investing, however, it is changes in market value that create returns, not market value per se. Since market values reflect expectations, there is no reason to believe that firms that have high CFROI will earn excess returns. The relationship between changes in CFROI and excess returns is more intriguing. To the extent that any increase in CFROI is viewed as a positive surprise, firms with the biggest increases in CFROI should earn excess returns. In reality, however, the actual change in CFROI has to be measured against expectations; if CFROI increases, but less than expected, the market value should drop; if CFROI drops but less than expected, the market value should increase

4.2 The association between economic value measures and DCF approach Fernandez (2002) shows that EP, EVA and CVA, if used for valuation purposes, are consistent with DCF approach. Analytically he shows that: • the present value of the EP discounted at the required return to equity, plus the equity book value

equals the value of equity (the present value of the equity cash flow discounted at the required return to equity);

• the present value of the EVA discounted at the WACC plus the enterprise book value (equity plus debt) equals the enterprise market value (the present value of the free cash flow discounted at the WACC);

• the present value of the CVA discounted at the WACC plus the enterprise book value (equity plus debt) equals the enterprise market value (the present value of the free cash flow discounted at the WACC).

Therefore, through the present value of EP, EVA and CVA we get the same equity value as the discounting the equity cash flow or the free cash flow. Therefore, it is possible to value firms by discounting EVA, EP or CVA, although these parameters are not cash flows and their financial meaning is much less clear than that of cash flows. Therefore, we can conclude that maximizing the present value of the EP, EVA or CVA is equivalent to maximizing the value of the firm’s shares.


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However, Fernandez (2002) also remarks that maximizing a particular year’s EP, EVA or CVA is meaningless: it may be the opposite to maximizing the value of the firm’s shares. The claim that the EP, EVA or CVA measures the firm’s “value creation” in each period is a tremendous error: it makes no sense to give the EP, EVA or CVA the meaning of value creation in each period. As the present value of the EVA corresponds to the MVA, it is common for the EVA to be interpreted incorrectly as each period’s MVA. In fact, he shows that it may happen that the EVA grows from negative to positive in a considered period but it depends on the fact that shares’ book value decreases as the fixed assets are depreciated. Furthermore, it may happen that the EVA and the EP in one year have been positive, and even higher than expected, but that the value of the firm or business unit has fallen because the business’s expectations have deteriorated. The EVA, EP and CVA do not measure value creation during each period. It is not possible to quantify value creation during a period on the basis of accounting data. Value always depends on expectations (Fernandez, 2002). EVA and DCF model EVA is a throwback to the net present value rule. Damodaran (2000) demonstrates that the present value of the EVAs by a project over its life is the NPV of the project. The NPV of a project can be written as follows:

11 1

where = depreciation and amortization

= salvage value = cost of capital

= initial investment n = expected life of the investment Now consider an alternative investment that requires an initial investment of I, earns exactly the cost of capital and allows for the entire investment to be salvaged at the end of the project life of n years. The net present value of this project will be zero. Solving for I in this case, we get:

1 1

Substituting this into the first equation, we get the net present value of the original project to be the following:

11 1 1 1

Now we assume that the project has a salvage value of zero, and that the present value of depreciation is equal to the present value of initial investment, discounted back over the project life. In other words, we assume that the cash flow from depreciation is really the capital being returned to the firm (alternatively we can assume that the CFs from depreciation payback I ‐ SVn). Then, the net present value of this project can be written as:

11 1

By noting that ROC=EBIT(1‐t)/I, then we get


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1 1

Thus, the NPV of the project is the present value of the EVAs by that project over its life. Note, however, that this relation is true only when the assumptions above are verified. The linkage between EVA and NPV allows us to link the value of a firm to the economic value added by it (Damodaran, 2000). Firm value can be expressed in terms of the value of assets in place and expected future growth as follows:

Firm Value Value of Assets in Place Value of Expected Future Growth

Note that in a DCF model, the values of both assets in place and expected future growth can be written in terms of the net present value created by each:

Firm Value Capital Invested Assets in Place NPVAssets in Place ∑ Future Projects, t

Substituting the EVA version of NPV back into this equation, we get:

Firm Value Capital Invested Assets in Place +∑ , ∑ , . Thus, the value of a firm can be written as the sum of three components, the capital invested in assets in place, the present value of the EVAs by these assets, and the expected present value of the economic value that will be added by future investments. A simplified EVA valuation model (easier to be used in boardrooms) can be derived as follows (Fabozzi and Grant, 2000)

1

1

The formula means that a firm will: • earn its NOPAT on its existing assets forever • earn positive EVA for ever on new investments made over period T • earn zero EVA on any new investments made after period T.

It is useful to note that the basic EVA model above assumes that competition has no effect on the existing assets or the new investments made through period T, but competition does effect investments made after T. In other words, if Wal‐Mart has 1000 existing stores, these stores will generate their existing level of profitability forever; plus any new stores added during the first T years will also generate economic profits into perpetuity. All stores added after T, however, will generate zero economic profits. Unfortunately, this is a very unrealistic model of how business works. Competition reduces the earning power of all assets, existing and future. And we can add that the basic EVA model does not provide guidance regarding T. Another way of presenting these results is in terms of MVA (Damodaran, 2000). The MVA is the difference between the firm value and the capital invested. Clearly, this value will be positive only if the return on capital is greater than the cost of capital, and will be an increasing function of the spread between the two numbers. Conversely, the number will be negative if the return on capital is less than the cost of capital. Note that the while the firm continues to grow in operating income terms and take new investments after the n‐th year, these marginal investments create no additional value if they earn the cost of capital. A


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direct implication is that it is not growth that creates value, but growth in conjunction with excess returns. This provides a new perspective on the quality of growth. A firm can be growing its operating income at a healthy rate, but if it is doing so by investing large amounts at or below the cost of capital, it will not be creating value and may actually be destroying it. Finally, we can derive several implications from the fact that the value of a firm can be written in terms of the present value of the EVA by both projects in place and expected future projects. First, a policy of maximizing the present value of EVA over time is equivalent to a policy of maximizing firm value. However, the notion that the EVA approach requires less information than a DCF valuation, or that it provides a better estimate of value is false. The EVA approach, done right, should yield the same value as a DCF valuation, and it requires more information, not less. In fact, the DCF valuation required cash flows and a discount rate to arrive at a value. The EVA approach requires these inputs and an additional one: the capital invested in the firm. It uses this measure to break firm value up into capital invested and EVA components. Note that changing the capital invested number has no impact on overall value. Finally, it is often claimed that the EVA valuations provide us with fresh insights on value enhancement because of its focus on excess returns, defined in terms of return and cost of capital. A DCF model where growth is linked to the reinvestment rate and the return on investments accomplishes the same objectives and arrives at the same results. CFROI and DCF model Damodaran (2000) shows the link between CFROI and firm value, by beginning with a simple discounted cash flow model for a firm in stable growth:

Firm Value FCFF1/ kc ‐gn This can be rewritten, approximately, in terms of the CFROI as follows:

Firm Value CFROI*GI‐DA 1 ‐ t ‐ CX‐DA ‐ ΔWC / kc ‐gn where FCFF = free cash flow to firm = EBIT 1‐t ‐ Capital Expenditures‐ Depreciation ‐ Change in Working Capital CFROI = cash flow return on investment GI = gross investment CFROI*GI = economic income DA = depreciation and amortization CX = capital expenditures ΔWC = change in working capital kc = cost of capital gn = stable growth rate. More important than the mechanics, however, is the fact that firm value, while a function of the CFROI is also a function of the other variables in the equation – the gross investment, the tax rate, the growth rate, the cost of capital and the firm’s reinvestment needs. Again, sophisticated users of CFROI do recognize the fact that value comes not just from the CFROI on assets in place but also on future investments. Holt Associates and BCG both allow for a fade factor in CFROI, where the current CFROI fades towards the real cost of capital over time. A company’s current value depends on competitive life‐cycle patterns that reflect expected future economic returns and reinvestment rates (Madden, 2007). The idea of competitive life‐cycles is based on the premise that competition and capital flows operate over the longer term to force companies’ economic returns toward the cost of capital. During the high innovation stage, returns are above their cost of capital and reinvestment exceeds internally generated funds. Attracted by the wealth creation opportunities,


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competitors attempt to duplicate innovations. Competition results in a tendency of economic return to fade towards the long term average of the corporate sector’s economic returns (which approximates the corporate sector’s long term cost of capital). Thus, corporate reinvestment rates fall back toward the lower, long term average growth rate of the overall economy. To maintain well‐above‐average economic returns and reinvestment rates over decades, companies must continually reinvent themselves to outperform competitors. The "fade factor" can be estimated empirically by looking at firms in different CFROI classes and tracking them over time. Thus, a firm that has a current CFROI of 20% and real cost of capital of 8% will be projected to have lower CFROI over time. Figure 1 displayed the life‐cycle model (panel A) and the life‐cycle track records of Kmart and Wal‐Mart in the 1960‐2005 period (panel B and C respectively), where the two companies’ CFROIs can be observed as well as a benchmark long‐term corporate average CFROI of 6% real to approximate the cost of capital (Madden, 2007). Wal‐Mart has been able to postpone the downward competitive fade of its superior CFROIs while still reinvesting at very high rates. This occurred because Wal‐Mart’s founder was skilled in hiring talented people, motivating employees and developing strategies that were extraordinarily effective as well as a step ahead of his competitors. His original strategy was to locate stores away from large cities and to saturate regions so the stores could be efficiently serviced by a centrally located distribution center. Figure 1 ‐ Life‐Cycle model and Kmart and Wal‐Mart life‐cycle performance panel A ‐ life‐cycle model

panel B – Kmart life cycle track

panel C – Wal‐Mart life cycle track

source: Madden (2007)


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His strategy proved correct as population expanded to where his stores were located. The remarkable achievement of creating the world’s largest retailer, along with over 1.7 million jobs, and huge shareholder value, had the additional social benefit of increasing the purchasing power of millions of customers through its discount pricing (Madden, 2007). The value of the firm, in this more complex format, can then be written as a sum of the following: − the present value of the cash flows from assets in place over their remaining life, which can be written

as ∑ where CFROIaip is the CFROI on assets in place, GIaip is the gross investment

in assets in place and kc is the real cost of capital − the present value of the excess cash flows from future investments, which can be written in real terms

as ∑ , ∆ ‐ ∆GIt, where CFROIt,NI is the CFROI on new investments made in year t

and ΔGIt is the new investment made in year t. Note that if CFROIt,NI = kc, this present value is equal to zero.

The key to avoiding perpetuity hypothesis is to determine when a company’s return on capital is equal to its cost of capital (i.e. discount rate). Afterward, no matter how much a firm grows, the net present value of future investments is zero. Thus, a firm's value will depend upon the CFROI it earns on assets in place and both the abruptness and the speed with which this CFROI fades towards the cost of capital. Thus, a firm can potentially increase its value by doing any of the following: − increasing the CFROI from assets in place, for a given gross investment − reducing the speed at which the CFROI fades towards the real cost of capital − reduce the abruptness with which CFROI fades towards the cost of capital.

Note that this is no different from an analysis of firm value in the discounted cash flow format in terms of cash flows from assets in place (increase current CFROI), the length of the high growth period (reduce fade speed) and the growth rate during the growth period (keep excess returns from falling as steeply).

4.3 Managerial implications of economic value measures From a managerial accounting standpoint, the key question is not whether economic value measures are more highly correlated with stock returns than traditional accounting measures, but whether the use of economic value measures for internal decision‐making, performance measurement, and compensation purposes improves organizational performance (Ittner and Larcker, 1998). Before debating whether the companies have in fact gained value by adopting the economic value measures, it is worth noting the way in which these measures have been put in practice. Since EVA is the most popular measure of performance and has widespread application across industries and continents, in the last decade we have seen a number of converts among corporations to EVA . Most firms that have adopted EVA as their value enhancement measure have also tied management compensation to it. Some firms have made it the sole basis for compensation, while others continue to use it in association with other compensation schemes (i.e. stock grants and stock options). The adopters of EVA still measure it looking at year to year changes rather than in terms of the present value of EVAs over time. The reward may be simply based upon achieving an EVA next year that is greater than this year's number. In other firms, managers are rewarded only if they beat the expected EVA. In almost no case is the reward based upon the present value of EVAs over time. This practice does create a significant potential for abuse, as we will see below. Firms that have converted to EVA have done so not just at the firm level, but also at the level of individual divisions or sub‐units within the firm. Thus, the success or failure of an employee is often measured by the EVA by the unit to which this employee is most closely connected. This practice makes the estimation problems about EVA much greater (Damodaran, 2000). Similar practices could be supposed about CFROI.


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As regard SVA, Rappaport (1999) explains the superior SVA approach for an incentive pay plan of operating managers at business units level (neither for CEO and corporate level executives nor for frontline managers). SVA puts value on changes in the future cash flows of a company or business unit. According to SVA approach, business units managers should be rewarded when they create superior SVA in their units. Calculating superior SVA requires six steps (Rappaport, 1999): − first, develop expectations for the standard drivers of value‐sales growth, operating margins, and

investments by factoring in historical performance, the unit's business plan, and competitive benchmarking;

− second, convert the expectations about value drivers into annual cash‐flow estimates and discount them at the business unit's cost of capital in order to obtain the value of each operating unit;

− third, aggregate the values of each operating unit to verify that the sum is approximately equal to the company's market value;

− fourth, from the cash flows used to value the operating unit, establish the annual expected SVA over the performance period‐typically three years;

− fifth, use year‐end results to compute the actual SVA at the end of each year. The calculation will he the same as in the previous step, with actual numbers replacing the estimates;

− sixth, calculate the difference between actual and expected SVA. When the difference is positive, you have superior SVA.

Since value creation prospects can vary greatly from one business unit to another, an approach based on expectations establishes a level playing field by accounting for differences in business prospects. Managers who perform extraordinarily well in low return businesses will be rewarded, while those who do poorly in high‐return businesses will be penalized. Setting the SVA threshold targets at 80% of a designated target would be appropriate. In addition, when setting performance pay, it is important to note that value creation is a long‐term phenomenon. Annual performance measures do not account for the longer‐term consequences of operating and investment decisions made today. So looking at a single year reveals little about the long‐term ability of a business to generate cash. To motivate managers to focus on opportunities to create superior SVA beyond the current period, the performance evaluation period should be extended to, say, a rolling three‐year cycle. Moreover, a breakdown of SVA drivers could be used in compensation and operations evaluation for middle managers and frontline employees, who need to know what specific actions they should take to increase SVA (being SVA too broad to provide much day‐to‐day guidance to them). For more specific measures, companies can develop leading indicators of value, which are quantifiable, easily communicated current accomplishments that frontline employees can influence directly and that significantly affect the long‐term value of the business in a positive way. Examples might include time to market for new product launches, employee turnover rate, customer retention rate, and the timely opening of new stores or manufacturing facilities. The process of identifying leading indicators can be challenging, but improving leading‐indicator performance is the foundation for achieving superior SVA, which in turn serves to increase long‐term shareholder returns (Rappaport, 1999). A 1995 survey by Sibson & Co. supports claims that many users of economic value measures do not base compensation on these measures (see Table 7): while 41.2 percent of respondents used economic value measures (i.e. measures such as EVA, CFROI, residual income, etc.) for business planning and financial management purposes, only 16.7 percent used these measures in incentive plans, of which only 26.3 percent made economic value the sole performance measure in these plans. In addition, many of the respondents used economic value measures only in annual incentive plans and not in long‐term plans, and relatively few used them at all organizational levels. Now we can analyze what is the potential for abuse in adopting the economic measures in managerial compensation, as illustrated above.


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Table 7 – Uses of economic value measures

source: Ittner and Larcker (1998) Assume that a firm adopts EVA and decides to judge managers based upon their capacity to generate greater‐than‐expected EVA (Damodaran, 2000). To answer this question, let us go back to the following equation, where firm value is decomposed into capital invested, the present value of EVA by assets in place and the present value of EVA by future growth.

+ ∑ , + ∑ ,

The first two terms in the equation (the capital invested and the present value of EVA by these investments), are both sensitive to how capital invested is measured. If capital invested is reduced, keeping the operating income constant, the first term in the equation will drop but the present value of EVAs will increase proportionately. When managers are judged based upon the EVA, there will be strong incentives to keep the capital invested down. Thus, if the reduction in capital invested came from closing down a plant that was not (and does not expect to) generate any operating income, the cash flow generated by liquidating the plant’s assets will increase value. However, if the reduction is purely cosmetic in terms of its effects on capital invested, thus does not create and may even destroy value. Some examples are: a) accounting changes that reduce the book value of capital, but do not generate tax benefits or higher operating income in future periods (for example, large one‐time restructuring charges); b) game playing once the rules for EVA measure have been defined (the incentive to lease rather than to buy assets); c) when EVA is estimated for divisions, the allocation of invested capital to the divisions will be based upon rules devised by the firm: while expected objective and unbiased, they could be subjective and over allocate capital to some divisions or under allocate capital to others. This misallocation is likely to reflect the power of individual divisions to influence the process: the EVA will result over estimated for the last and under estimated for the former. Furthermore, the value of a firm is the value of its assets in place and the value of its future growth prospects. When managers are judged on the basis of EVA in the current year, or on year‐to‐year changes,


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the EVA that is being measured is just that from assets in place. Thus, managers may trade off the EVA from future growth for higher EVA from assets in place. In addition, the present value of the EVA is not just a function of the dollar EVA but also of the cost of capital. A firm can take actions that increase its EVA, but still end up with a lower value, if these actions increase its operating risk and cost of capital. When managers are judged based upon year‐to‐year EVA changes, there will be a tendency to shift investments into riskier investments. This tendency will be exaggerated if the cost of capital does not reflect the changes in risk or lags it (beta estimates that are based upon historical returns will lag changes in risk). In closing, EVA is an approach that is skewed towards assets in place and away from future growth (Damodaran, 2000). It should not be surprising, therefore, that when EVA is computed at the divisional level of a firm, the higher growth divisions end up with the lowest EVA (in some cases with negative EVA). Again, while these divisional managers may still be judged based upon changes in EVA from year to year, the temptation at the firm level to reduce or eliminate capital invested in these divisions will be strong, since it will make the firm’s overall EVA look much better (Damodaran, 2000). Although the relationship between CFROI and firm value is less intuitive than the relationship between EVA and firm value, partly because it is a percentage return, the games that managers can play, when their performance is judged on the basis of the CFROI, are similar to those noted in discussion of EVA. The first is the capital game, where the CFROI is increased while the gross investment is reduced. Since it is the product of the two that drives value, it is possible for a firm to increase CFROI and end up with a lower value. Thus, managers of firms judged on the basis of CFROI will do everything in their power to keep the gross investment as small as possible. CFROI, even more than EVA, is focused on assets in place and does not look at future growth. To the extent that managers increase CFROI at the expense of future growth, the value can decrease while CFROI goes up. This is because the effects of the growth sacrifice are likely to be observed in the fade factor, and unless this can be precisely estimated and compared to what it should have been, the growth game will continue to be paid (Damodaran, 2000). While the CFROI is compared to the cost of capital to pass judgment on whether a firm is creating or destroying value, it represents only a partial correction for risk. The value of a firm is still the present value of expected future cash flows. Thus, a firm can increase its spread between the CFROI and cost of capital, but still end up losing value if the present value effect of having a higher cost of capital dominates the higher CFROI. In general, then, an increase in CFROI, by itself, does not indicate that the firm value has increases, since it might have come at the expense of lower growth and/or higher risk. Since the focus of SVA is future performance, it is difficult to apply when measuring historic performance. However, the focus on superior SVA as difference between actual and expected SVA, in a medium term span, should orient correctly the operating managers to find strategies with the highest potential for increasing value, avoiding the short‐term performance obsession. We will examine now empirical evidence about effects on managerial behaviour induced by the adoption of the economic value measures. Wallace (1997) examined relative performance changes in 40 adopters of residual income‐based measures such as EVA, EP and CVA and a matched sample of non‐users supports claims that these measures change managerial behaviour. Compared to the control firms, the residual income firms decreased new investments ( ‐21%), increased payouts to shareholders through share repurchases (+112%), sold (or withdrew) 100% more assets and utilized assets more intensively, leading to significantly greater change in residual income. These actions result to be consistent with the strong rate of return discipline associated with the explicit capital charge in residual income‐based measures.


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Wallace also found weak evidence that stock market participants responded favourably to the adoption of residual income‐based compensation plans. Kleiman (1999) compared the performance of 71 companies that adopted EVA between 1987 and 1996 with that of its most direct competitors that did not adopt the EVA. He demonstrated that adoption of EVA‐based performance evaluation system resulted in substantial improvements in EBITDA and operating margins, faster asset turns and stronger cash flow generation, which are in turn the drivers of the superior stock market performance of these companies. Sale of assets increases significantly after introduction of the EVA, too. Thus, adoption of EVA led to substantial internal improvements, which resulted in higher shareholder returns than their immediate competitors: 2.6% in the year of introduction, and 5.7%, ‐1% and 11.1% during the following years. No empirical evidence is available on effectiveness of SVA in managerial compensation systems. A related issue is whether the performance implications of economic value measures depend upon how the measures are used within the organization. Stern Stewart argues that effective implementation of EVA requires firms to make this measure the cornerstone of a total financial management system that focuses on EVA for capital budgeting, goal setting, investor communication, and compensation (Stern et al., 1995). Stewart (1995) asserts that the poor results from many EVA implementations are attributable to the fact that EVA use has not become pervasive throughout the organization, especially for compensation decisions. The firm attributes the lack of success in many EVA implementations to four factors: 1) EVA is not made a way of life; 2) EVA is implemented too fast; 3) lack of conviction by the CEO or division head; 4) inadequate training (Stewart, 1995). As reported in a Stern Stewart study (www.EVA.com) companies that implemented EVA in the 1990’s outperformed their peers by an average of 8,3% per annum over the five years following adoptation and created total excess shareholder wealth of $ 116 billion. A more recent study of the performance of EVA companies concentrating on the period since the peak of the stock market on march 2000 through midyear 2002 showed that the portfolio of Stern Stewart’s EVA clients earned a total return of 36,5% and beat the S&P 500 by a total of 69,8%. The performance differential was even more significant for companies that have reinforced EVA as a performance measure and decision tool by tying management incentives to EVA. Those firms earned a 64.5% whereas companies that used EVA only for performance measurement earned a 20,2% return and beat the market by 53,5%. The evidence seems to be consistent with the contention that EVA works best when it is used in a powerful bonus plan that stimulates the incentives of ownership and directly aligns the interests of managers and employees with those of the owners. But tests and data are provided by Stern Stewart, which is strongly interested to support the most pervasive use of EVA. Biddle et al. (1998) provide some evidence that the use of economic value measures in compensation plans is associated with the measures’ effectiveness. The only subsample in which EVA outperformed traditional accounting measures in predicting stock returns was firms using EVA in compensation plans. Similarly, the Sibson & Co. survey indicates that 26.3 percent of firms using economic value measures in incentive plans reported that these measures were "very successful" and 36.8 percent reported they were "marginally successful." None of the respondents stated that the measures were "not successful." The 31.5 percent of respondents who were "not sure" of the measures' effectiveness were all recent adopters. Wallace (1997) also identified a group of 36 firms that used a residual income measure to some extent in their decision making, but that have not included the measure in their incentive compensation. On this sample the same tests performed in the main sample are repeated. The results are generally weaker for these firms (than 40 adopters in compensation plans), with only significant results observed for the asset disposition test. The observed results for the financing, operating, and residual income tests are all insignificant. These results support the contention that residual income‐based performance measures only work if they are used in compensation plans.


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Wallace's (1998) survey of EVA users found that firms including EVA in their incentive compensation plans also implemented the measure to a significantly greater degree for capital budgeting and dividend decisions, but not for asset disposal, working capital management, share repurchase, or financing decisions. Firms using EVA in incentive plans also reported significantly greater awareness of the cost of capital, reduced average accounts receivable age, increased use of debt, increased sales revenues and a longer accounts payable cycle. However, changes in the degree of selectivity in the choice of new investment projects, inventory turnover, share repurchases and debt repayment were not statistically different in the two EVA user groups.

5. A COMPARISON: STRENGTHS AND WEAKNESSES OF THE ECONOMIC VALUE MEASURES The following table (Fernandez, 2003) proposes a comparison between EVA and CFROI (through CVA). Cwynar (2009) define EVA, CVA and RI as accounting‐based variants of residual income approach because they utilize book values of both operating income and invested capital, although more or less adjusted (unadjusted for RI) in order to eliminate or limit the distortions of accounting numbers. Conversely, SVA is based directly on the DCF concept. The “Refined Economic Value Added" (REVA), elaborated by Bacidore et al. (1997), is considered a hybrid metric, because it calculates EVA applying the cost of capital to the opening market value (rather than book value) of the firm's equity plus debt.

Table 8 – A comparison between EVA and CVA

source: adapted from Fernandez (2003).

If all value‐based metrics have similar goals, then why are there different metrics? A cynic might answer that it gives all the consultants something to argue about. Although this hypothesis definitely has merit, the reality is that different metrics are likely to serve different purposes (Fabozzi and Grant, 2000). The principal users of value‐based metrics are money managers/analysts and corporate executives. Each party has unique needs and access to information when carrying out their daily activities. For instance, money managers need a metric that allows them to quickly evaluate hundreds and even thousands of companies on the basis of publicly available information. They evaluate management’s skill by looking at management’s historic and forecasted track record relative to peers, and then determine whether the firm is over or undervalued based on their expectations. Contrast this to corporate executives who have almost limitless information on a single firm. The firm, however, is made up of several business units, hundreds of projects and thousands of employees. Corporate executives must not only make strategic decisions to help

EVAeconomic value added

CVAcash value added

measure of shareholder

value creation

EVA=NOPAT – (Ebv + D) WACC

CVA = NOPAT + DEP – EDEP – (DO+EbvO) WACC

(DEP = accounting depreciation; EDEP = economic depreciation)

EVA= (ROC‐WACC)(D+Ebv)

CVA = (CFROI‐WACC) x (DO+EbvO)

measure of shareholder

return

ROC = ROA = NOPAT/ (D+Ebv) (NOPAT= net operating profit

after taxes and after adjustments)

CFROI = (NOPAT + DEP – EDEP)/(DO+EbvO)

assets in place

D+Ebv = adjusted book value of debt and equity

(D= debt , Ebv = book value of equity)

(DO+EbvO) = working capital requirements + fixed assets +

cumulated depreciation + inflation adjustment


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the firm create shareholder value, they must also promote and instill value‐based management principles throughout the organization down to the lowest levels. In addition, they must design and maintain internal management systems to ensure that the firm does not stray from the designated path. Although always aware of the external demands of the market and pressure from competition, the corporate executive’s predominate focus is internal, with a primary emphasis on managing the operational details of running a business. In short, money managers want a performance metric that is comparable across a large number of firms and a valuation system that objectively sets target values. Corporate executives want the same properties, but are much more interested in a simple measure that is easy to communicate and administer throughout the firm. Can one framework meet the needs of both parties? As discussed earlier, a primary goal of value‐based metrics is to eliminate the numerous distortions in accounting data to provide comparability across time, firms and industries. Once we have cleaned up the accounting data, we can evaluate if companies are creating or destroying shareholder wealth and provide more insightful valuations. EVA and CFROI are similar along this aspect; on the contrary, SVA utilizes in computation DCF approach directly and does not introduce accounting distortions. However, unlike CFROI, EVA includes depreciation twice in the earnings and investment portion (by subtracting twice as expense in the earnings portion of the calculation and again in the investment value upon which the cost of capital is subtracted). Utilizing these items in a performance metric can cause many difficulties for a manager who is trying to compare firms across time and industries to determine the best investment opportunity. For example, how does a manager compare EVA for two firms when one firm uses accelerated depreciation and the other straight‐line? Or what about firms having similar fixed assets that were purchased at different times? In addition, the manager must determine if the net asset base adequately accounts for the money the firm has invested to generate its cash flows (e.g. the firm may have fully depreciated, but not retired fixed plant) and whether depreciation expense is sufficient to replace the existing fixed assets. These issues have additional implications for the corporate executive. The EVA calculation’s reliance on “net plant” can lead corporations to confusing conclusions regarding wealth creation and optimal strategy. Fabozzi and Grant (2000) call this effect “the old plant trap”. As a project gets older, EVA increases. Why? Has the project’s economics changed? No, the basic EVA calculation increased only because the plant was depreciated, which decreased the capital charge each year. In addition, which EVA is the “correct” EVA, and how does a manager know whether to accept or reject the project? This calculation issue has serious implications on management incentive mechanism. If a company adopt a compensation system that rewards improvement in EVA, managers are likely to resist growing since each new project will incrementally decrease their EVA, while doing nothing increases it. Inflation makes the problem even worse (new investments are expressed at current prices). EVA can deal with the “old plant trap” by replacing the accounting depreciation with the annuity (economic) depreciation. Obviously, such a solution is not as easy, further for external analysts. Unlike EVA, CFROI is an internal rate of return and not a measure of economic profit. It provides a consistent basis from which to evaluate companies regardless of their size. This characteristic of CFROI has made it very popular in the money management community, as investors need to compare many companies against each other to make investments decisions (Fabozzi and Grant, 2000). However, CFROI does not eliminate the hurdle rate problem, in which companies set an acceptable rate of return (the cost of capital) and assess performance based on the actual rate achieved. Thus, companies are discouraged from investing in projects that would be expected to achieve a lower return, compared to the presently employed assets, even if it exceeds the hurdle rate. It would result in a greater positive cash flow for the company, but lower total rate on the portfolio of investments. Because it lowers the overall performance evaluation criterion, it discourages approval of the project even though it would be beneficial to the whole company. In addition, as well as IRR, CFROI is a rate‐based measure and can provide a moving target based on assumptions regarding reinvestment that may or may not be true (given two projects with equal NPV but differing timing and amounts for cash flows, IRR will often produce different answers). Finally, CFROI is


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a non‐linear measure: therefore, it is not easy for a manager to link how much he needs to improve cash flow to obtain a target increase in CFROI. Unlike EVA and CFROI, the SVA approach is likely to be more appropriate for corporate planning because corporate planners want to understand how changes in strategy will affect their company’s value. The SVA includes strategy‐specific forecasts and therefore the strategic implications of the SVA model are more clear and intuitive. Moreover, it focuses on the standard drivers of value (sales growth, operating margins, investments, cost of capital). However, since the focus of SVA is future performance, it is difficult to apply when measuring historic performance and then it could be considered less adequate in compensation systems. However, as discussed above, since the focus of SVA is future performance should orient correctly the operating managers to find strategies with the highest potential for increasing value. We will sum up as follows the strengths and weaknesses of the three value‐based measures analyzed. EVA Fundamentally EVA has two sound features: − by focusing attention on “surplus” value, it does stress that it is not how much income a firm makes

that marks its success, but how much it makes in excess of its cost of capital − by making this measure an absolute measure (rather then a spread of rates) it helps firms recognize

that refusing projects that earn more than their cost of capital (just because they earn less – or a smaller spread – than do existing projects) can be value destroying.

EVA, on the other hand, shows various shortcomings. − it is distorted by the effect of “the old plant trap” and this calculation issue has serious implications

on management incentive mechanism − it is not a revolutionary way of thinking about financial decisions (as its proponents claim): EVA is just

NPV presented differently and valuing a firm using EVA requires more information than DCF models, not less (Damodaran, 2000)

− it is very dependent on accounting measures of operating income and capital invested, though adjustments are made to both as demonstrated by a very strong relationship between adjusted and unadjusted EVA (Anderson et al., 2005)

− it could be inconsistent with value creation. The value of a firm’s assets is the present value of the EVAs generated by them. Thus, a firm could be generating a positive EVA in the current year from assets, but the expected EVA in future years may be negative, making these assets poor investments. Conversely, you can have a firm generating negative EVA in the current year, but the assets could still be value creating if the present value of expected future EVAs is positive. Similarly, if a firm increases its EVA this year relative to last year’s EVA or even relative to expectations, it could not stated that it has increased its value, but it might have done so by trading off against future growth or increasing its riskiness

− neither strong nor univocal evidence exists on a higher correlation between EVA or EVA’s increases and market value increases than other traditional metrics as well as rival economic value measures

− EVA has been criticized for being too complex for front‐line managers to use, for motivating managers to reduce beneficial capital expenditures to improve short‐term EVA, and for ignoring the firm's "core competencies" and providing little actionable information on the long‐term drivers of firm value. For example, AT&T was once touted in the business press as a leading proponent of EVA, but has since abandoned this measure (Ittner and Larcker, 1998). Prior to an internal reorganization in the early 1990s, performance was evaluated based on measured operating income and measured operating units (a service volume indicator), and no variable compensation was awarded. In 1992, the firm adopted EVA for decision‐making and compensation purposes, and implemented an EVA‐based bonus plan covering approximately 110,000 employees. However, EVA was supplemented by two new nonfinancial measures ("customer value added" and "people value added" within two years: the last was based on employee satisfaction, work force diversity, employee turnover/retention, work force


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health, and leadership visibility; the former was based on customers' satisfaction with price and with product, service and contact quality), and was abandoned altogether by 1997 in favour of traditional accounting measures. Three primary reasons for the measure's demise in AT&T were identified: the measure was too complex for most employees to understand, even though AT&T made

relatively few of the accounting adjustments recommended by Stern Stewart. Despite extensive training in the computation and use of EVA, employees outside of corporate headquarters did not understand how their actions affected EVA results, and felt they had limited ability to impact corporate or business unit EVA targets

the company came to recognize that EVA was an historical measure that provided incomplete information on key drivers of future performance, such as employees and customers

although internal EVA results were positive, total shareholder return between December 1992 and December 1996 (the period covered by the EVA measure) was ‐6.46 percent. The inconsistencies between reported EVA and stock returns, combined with the hiring of a new CEO who had not championed the EVA system, led the firm to drop EVA in favour of traditional accounting performance measures they believe to be more closely aligned with analysts' forecast models and shareholder value.

CFROI There are some firms with significant capital rationing constraints, where it is critical that investments be directed to those projects where they earn the highest possible returns for the firm. For these firms, it can be argued that value added measures that focus on euro (or dollar) value may lead to a misallocation of resources, since they implicitly assume that there is sufficient capital to take on all good projects. Using a percentage rate of return allows these firms to get the maximum return from limited capital. Furthermore, as a rate of return, CFROI is well designed as a tool to assist the institutional investors in picking stocks: for this purpose they need a systematic means of sorting through the historical data of thousands of businesses to identify potentially undervalued companies and to be able to back test the model to identify how well it did in the past. Adopting for this purpose an economic metric like SVA, for example, would simply be too time consuming, because it needs explicit separate yearly cash flow estimates, cost of capital and forecast periods for each company. It is not clear, however, that CFROI is a significant advance over even traditional accounting measures such as ROI or ROC. Unlike accounting return measures and even EVA, CFROI focuses on cash flows. This is partially true, since non‐cash charges are added back to arrive at the gross cash flow, but the cash flow used in CFROI calculations is not the cash flow available for claimholders in the firm because it is prior to capital expenditures and it is stated in real terms. In addition, CFROI avoids accounting distortions by excluding depreciation, but accounting depreciation affect calculation of asset life (as average depreciation period). The traditional accounting measures of return tend to be overstated because they look at the remaining book value of assets. Thus, as assets are depreciated, the return on equity and capital tend to increase. By focusing on the gross investment, rather than the net, and adjusting for current dollars, it is argued that CFROI provides a superior measure of return on an investment. This argument, however, tends to work better for manufacturing firms but does not really hold up for firms that are not capital intensive. Furthermore, it is argued that by assuming a fixed life for an asset and computing an internal rate of return, the CFROI provides a better measure of return than traditional accounting measures which often divide current earnings by book value of investment. This, again, is a far better argument with capital intensive firms that invest in plant and equipment than it is for firms that invest in short term and intangible assets. Furthermore, if we assume that assets have infinite lives and that capital maintenance expenditures offset depreciation, the CFROI measure converges on the return on capital. Moreover, CFROI does not eliminate the hurdle rate problem, in which companies set an acceptable rate of return and assess performance based on the actual rate achieved. Thus, companies are discouraged from investing in projects that would be expected to achieve a lower return, compared to the presently employed assets, even if it exceeds the hurdle rate (the cost of capital). As well as IRR, CFROI is a rate‐


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based measure and can provide a moving target based on assumptions regarding reinvestment that may or may not be true. While it is a useful tool for picking stocks, it is less useful for corporate planning. Corporate planners want to understand how change in strategy will affect their company’s value. Based on a series of average assumptions (cash flows determined by a 40 year CFROI fading to country‐wide averages, constant cost of capital, etc.) in order to avoid explicit forecasts, CFROI will miss the distinctions (it was defined a sort of "Procrustean Bed" approach to corporate valuation). Corporate planners want to understand how changes in strategy will affect their company's value. If you have the average company with the average strategy and the average investment policy and the average level of systematic risk and your strategy is not going to change, then CFROI approach will model your firm effectively. For any company that is not average on all these accounts, the BCG model will miss the distinctions. For example, would a natural resources company really want to "fade" to the same CFROI and the asset growth as a computer company? BCG's model would have it that way despite the fact that the rates of return and investment growth vary significantly from firm to firm and industry to industry (www.valueanalitix.com). Braxton Associates stated that a value‐based system using CFROI will be unsuccessful without a value driver analysis that unbundles CFROI into discrete, controllable financial and operational variables (Snyder, 1995). Therefore, it appears as a too complex measure for managers to understand and act upon, even if it is conceptually superior to traditional accounting measures and EVA. It would be difficult to explain CFROI to the average operating manager, much less his/her specific role in making it happen. SVA The shareholder value approach has gained popularity mainly because of the following reasons: − it accounts for risk, free from accounting distortions and measures the change in value − the approach uses complete information. It incorporates historical, current and forecast information in

determining the amount and timing of future cash flows, the value growth duration and systematic and specific risk in its analysis

− the SVA methodology concentrates on the residual claimants of the company. By choosing the strategies which create the highest value for the shareholders, the management also creates the highest value for other stakeholders like employees, other investors in the company and customers

− in the literature many surveys state the high correlation between cash outflow, downside stock price movements and decreasing shareholder value. From this research and experience, the discounted cash flow approach to understand investor expectations has established its position as a pre‐eminent, but not exclusive, analytical tool for value based management

− the SVA approach is likely to be more appropriate for corporate planning because corporate planners want to understand how changes in strategy will affect their company’s value. The SVA includes strategy‐specific forecasts and therefore the strategic implications of the SVA model are more clear and intuitive. Operating managers need to identify and focus on leading indicators to deliver superior value to shareholders.

Common criticisms on the SVA approach are the subjectivity, the high sensitivity of the residual value to the cash flow, the reliance on CAPM approach for determining the discount rate, the shortcomings in the area of compensation. We will analyze them shortly, reporting also the arguments in defence by SVA advocates (www.valueanalitix.com): − subjectivity. It is correct to say that the SVA approach is subjective. The SVA approach preferably

involves specific forecasts about operating factors into the future. Because it incorporates managerial judgement and strategic thinking, subjectivity is also necessarily added. Certain other approaches avoid this subjectivity only at the cost of relying on historical data and applying restrictive assumptions about the future


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− sensitivity of the residual value. Residual value is highly sensitive to the cash flow in the last forecast period and the rate of growth in perpetuity. To address the cash flow concern, the SVA approach excludes non‐recurrent events and normalizes the cash flow used as the basis for residual value. That residual value should be highly sensitive to the growth in perpetuity assumption. A firm that can create value indefinitely into the future (i.e. one with a perpetuity growth greater than zero) should be much more valuable than one that does not. It should be stressed that the perpetuity with growth assumption for residual value is only applicable to the very few firms that have an economic advantage that cannot be reduced by competition.

− reliance on CAPM. The SVA approach does not solely rely on CAPM as a mean of determining the discount rate. The SVA methodology can incorporate any method of estimating systematic risk, be it CAPM, APT or any other approach.

− shortcomings in the area of compensation. Compared to the EVA, the SVA approach is likely to pose the most important question in performance measurement – whether a company earns a better return on its investment than its cost of capital – less directly. A direct result of asking this question is that the focus is on returns higher than the cost of capital, even if that return is decreasing. Since the focus of SVA is future performance, it is difficult to apply when measuring historic performance. However, the focus on superior SVA as difference between actual and expected SVA, in a medium term span, should orient correctly the operating managers to find strategies with the highest potential for increasing SVA, unlike EVA and CFROI that can induce distorting behaviours.

Appendix – Formulas of CFROI From the following formula

1

we can demonstrate how the following alternative formulation of the CFROI can be derived, if we assume in deriving the economic depreciation a discount rate of kc CFROI k

CFROI Gross Cash Flow ‐ Economic Depreciation /Gross Investment. Stating that: ED = economic depreciation = GI – SV * , where = 1 1 ⁄ is the final value of an n‐period annuity with interest rate k multiplying each member of the above equation by 1 k n and therefore subtracting by each member GI, we can rewrite the relationship as follows: GI 1 k n ‐1 GCF * – ED * . Being 1 k n ‐1 k * and * 1 k n , we can get k*GI GCF – ED therefore k GCF – ED /GI (quod erat demonstrandum).


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