EVA versus Earnings: Does It Matter Which Is More Highly Correlated with Stock Returns?

Abstract

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