Evidence on EVA

Abstract

Economic Value Added (EVA) has attracted considerable attention as an alternative to traditional accounting earnings for use in both valuation and incentive compensation. With a host of consultants now marketing related metrics, numerous claims have been made - most based on anecdotal evidence or in-house studies. This paper summarizes independent evidence regarding EVA's alleged advantages. We begin by reviewing the theory that links the underlying concept of residual income to shareholder value. Second, we discuss how Stern Stewart modifies residual income to produce its proprietary EVA metric and show how median EVA compares with residual income, net income and operating cash flows over the period 1988-97. Third, we examine the claim that EVA is more closely associated with stock returns and firm value than is net income. The evidence indicates that EVA does not dominate net income in associations with stock returns and firm values. Fourth, we examine a second claim that compensation plans based on residual income motivate managers to take actions consistent with increasing shareholder value. Here, the independent evidence suggests that managers do respond to residual income-based incentives. Finally, we discuss how a metric such as EVA can be useful for internal incentive purposes even if it conveys little news to market participants regarding the firm's valuation.