FOKUS EKONOMI, DESEMBER 2002
EVA: An Alternative of Financial Performance Measurement
Fakultas Ekonomi Univ. Sanata Dharma Yogyakarta
Diskusi, mengenai pengukuran kinerja keuangan perusahaan, senantiasa dilakukan karena hasil penelitian menunjukkan terdapat perbedaan dalam menyimpulkan alat ukur kinerja perusahaan yang paling tepat. Tulisan ini mengantarkan pembaca untuk memahami beberapa teori dan hasil penelitian yang berkaitan dengan alat ukur yang disebut dengan EVA. Namun demikian, hasil penelitian menunjukkan kesimpulan yang berlawanan. Di satu sisi, sebagian peneliti menyatakan bahwa EVA merupakan prediktor yang lebih baik dibandingkan dengan alat ukur konvensional. Di sisi lain, sebagian peneliti menyimpulkan bahwa EVA tidak memiliki kelebihan dibandingkan alat ukur konvensional atas kinerja keuangan perusahaan.
Dengan menggunakan konteks Indonesia, penulis hanya menemukan satu penelitian yang dipublikasikan. Hal ini menunjukkan bahwa penelitian yang berkaitan dengan EVA masih langka. Dalam penelitian tersebut, EVA dibandingkan dengan ROA dalam kaitannya dengan return saham. Hasil yang diperoleh tidak sejalan dengan penelitian terdahulu. Oleh karena itu, tulisan ini diharapkan dapat digunakan sebagai awal penelitian lain yang berkaitan dengan EVA.
Kata Kunci: EVA, conventional measurements, kinerja keuangan, return saham.
Measuring company’s performance becomes a long discussion. Two different interests related to measurement have caused this situation, namely the interests of management and owners. Management, on one hand, has its own interests due to the company’s performance, because management will be evaluated its performance regarding their rewards based on their ability to achieve certain objectives. The interest of management relates to a short period of the company’s performance.
On the other hand, owners of the company also have interests in the performance with regard to their investments in the company. In addition, the owners’ interest emphasizes a long-term perspective. The owners consider the ability of the company to survive for longer period.
In order to abridge the difference interests above, there are several performance measurement tools expected to cope with the interests. The tools can be categorized into two groups of the measurement, namely conventional or traditional measurements and economic value added.
It was claimed that economic value added (EVA) is more useful compared to traditional measurements. This was supported by several studies that showed a dominance of economic value added. The findings demonstrated some empirical evidences that economic value added has a stronger explanatory power due to stock returns than conventional performance measurements. Nevertheless, some other studies did not come up with similar conclusions. They exhibited contrary results. They concluded that economic value added did not dominate other performance measurements.
Based on the contradictory findings above, this paper is aimed to review the relationships between economic value added and the others.
REVIEW OF LITERATURE
The review consists of several parts. The first part of the review will contain discussion of several traditional performance measurements of company’s value. The second part will discuss the emerging alternative performance measurement, namely economic value added. The last part of the review will show several studies related to a comparison of explanatory power of the measurement.
CONVENTIONAL PERFORMANCE MEASUREMENT
In the 1980s, shareholder activism reached unprecedented levels and led to increased pressure on firms to maximize shareholder value consistently. (Bacidore dkk. 1997) The trend was caused by the problem to align management’s interest and shareholders’ interest. Therefore, it is important to set up a measurement tool to evaluate performance of firms reflected both of the interests.
The obvious metric for judging firm performance is the stock price itself. Stock price, however (or returns based on stock price), may not be an efficient contracting parameter because it is driven by many factors beyond the control of the firm’s executives. (Bacidore dkk. 1997) Therefore, any financial performance measurement used in valuing firm’s value, on one hand, must correlate highly with changes in shareholder wealth and the other, should not be subject to all of the randomness and "noise" inherent in a firm’s stock price.
One of the performances that creatively linked the firm’s accounting data to its stock market performance is Economic Value Added owned by Stern Stewart Management Services. Tully (1993) stated that one of Economic Value Added’s most powerful properties is its strong link to stock prices.
Before examining the correlation between shareholder wealth and a performance measure, one must first define the appropriate way to measure changes in shareholder wealth. We contend that shareholders are concerned with the abnormal return they earn in any period - that is, the return they earn in excess of what they expected to earn for a firm within a given systematic risk class. When this return is positive, shareholders have more than covered their risk-adjusted opportunity cost of providing their capital. On the contrary, when this return is negative, they have been inadequately compensated for risk. Given this relationship, a good financial performance measure should correlate highly with abnormal stock returns.
Measures of shareholder wealth creation focus on the firm’s stock price performance and seek to determine how much shareholders increase their wealth from one period to the next based on the dividends they receive and the appreciation in the firm’s stock price. In the other words, shareholders can earn a return on their investment in two ways: through dividends and through capital gains. Over any period of time, t, the shareholder return for the firm j can be specified as: (Bacidore et al., 1997)
Rj,t = Shareholder return for the firm j over any period time t
Dj,t = The devidends paid during the period t-1 to t
Pj,t = The price of the shares at the end of period t
Pj,t-1 = The price of the shares at the end of period t-1
Many factors influence Rjt, most notably, the risk of the investment, the interest rate prevailing in the capital market, and the expertise of the firm’s managers. The capital pricing model (CAPM) captures the first two factors by specifying that the expected returns on a stock investment is: (Bacidore et al., 1997)
Rft = The risk-free bond yield at time t
bj = Firm j’s beta, a measure of the firm’s systematic risk.
E(Rmt)-Rft = The expected equity market risk premium, usually taken as the long-run, average realized return on the market in excess of risk-free bond returns.
The CAPM thus helps to determine the abnormal return firm j earned in the period t, this is called as return alpha and it calculate as follows: (Bacidore et al., 1997).
aj,t measures the actual shareholder return in excess of the return that was expected in a period, given the firm’s systematic risk. Alpha is the appropriate measure of shareholder wealth creation in any given time.
EVA AS A RELIABLE PERFORMANCE MEASUREMENT
One of the classic challenges of corporate governance has been to define and implement an ambiguous measure of performance correlated well with shareholder wealth creation. (Uyemura dkk. 1996) According to Uyemura et al. Economic Value Added becomes a primary performance measurement, which can align the interest of management and shareholder. If a company has a positive EVA, the company’s manager adds wealth to the shareholders. It is because the post-tax rate of return on invested capital exceeds the weighted-average cost of capital. On the other hand, if the company has a negative EVA, it means that the company’s managers destroy market value by investing in capital projects that can not cope with the returns of debt and equity. (Grant 1996).
EVA is an operational measure that differs from conventional earnings measures in two ways: (Uyemura dkk.1996).
1. EVA explicitly charges for the use of capital and, for this reason, is sometimes referred to as a "residual income" measure; and
2. EVA adjusts reported earnings to minimize accounting distortion and to better match the timing of revenue and expense recognition.
Traditionally, investors or other parties look for an appropriate measurement to assess management’s performance with regard to shareholder’s wealth creation. Earnings per share growth return on assets return on equity, market capitalization, and others are the most popular measurement. But Uyemura dkk (1996) questioned the ability of all of the measurement above in order to answer the most basic question that how to measure alignment between the success of management and the increasing shareholder wealth.
Uyemura dkk (1996) noted that shareholder wealth creation could be measured by using market value added (MVA). They defined MVA as a difference between the current market value of all capital elements and the historic dollar amount of capital invested in the company. Therefore, MVA can be formulated as follow:
MVA = Market Capital - Invested Capital
Further, Uyemura dkk mentioned several considerations how to select operational performance. Operational performance should fulfill the following considerations: (Uyemura dkk. 1996).
It should show a strong correlation with the changes in MVA;
It should be robust enough to be used for all financial management activities;
It should be measurable at all levels of the organization and in all dimensions.
It should be practical and effective as the basis for a value-based incentive compensation program.
Uyemura dkk (1996) proposed the following operational measurement that in line with the considerations above:
1. Net income
2. Earnings per share
3. Return on assets
4. Return on equity
5. Economic value added
The first four are traditional performance measures, while the last is recently adapted to certain companies. According to Ehrbar and Stewart (1999), Economic Value Added is a measure of corporate performance that differs from the most others by charging profit for the cost of all the capital a company employs. In line with previous definition f EVA, Uyemura dkk (1996) defines EVA as a measurement of firm’s profit after subtracting the cost of all capital employed. Below is how to calculate EVA: (Uyemura dkk. 1996; Mc Laren 1999)
EVA = (Return on Capital – Cost of Capital) * Capital
= ((Capital * Return on Capital) – (Capital*Cost of Capital)
= NOPAT – (Capital * Cost of Capital)
= NOPAT – Capital Charge
NOPAT represents "net operating profits, after tax", while capital charge is the amount of capital multiplied by the cost of capital.
According to Uyemura dkk (1996), there two differences between EVA and conventional earnings: First, EVA used NOPAT that reflected operational profits adjusted to minimize accounting conventions that misrepresented economic flows or that distort the proper matching of revenues and expenses.
Second, EVA assumed that management must generate sufficient revenues not only to cover operating expenses and the interest charges on debt, but also to provide the return that shareholders require to compensate them for the risking of their equity investment in the company.
In the other words, Uyemura dkk (1996) stated that traditional measures, namely net income, ROA, ROE, and earnings per share did not properly reflect the risk. Therefore, it is possible that management will behave too aggressive, for instance to maximize earnings, or, on contrary, management is possible to act conservative due to preventing dilution of returns. In bottom line, Uyemura dkk (1996) concluded that there is no "return" or "ratio" that can be employed to measure accurately shareholder value creation.
Process of EVA Calculation
Based on the study of Hartono and Chendrawati (1999), EVA can be calculated by the following steps:
1. Calculation of Annual Debt Expense.
kd = annual debt expense
Interest expense after tax can be calculated as follows:
kd* = annual debt expense after tax
t = tax rate
In accordance with Act in Second Revision of the Income Tax Act of 1984, effective January 1, 1995, a tax rate of 35 percent was used for 1994, and rate of 30% for the following years.
2. Calculation of Stockholders’ Equity Expense
Rit = Return on stock for the-ith firm in week t
Pit = Closing stock price on Friday of tweek t for the-ith firm
Pit-1 = Closing stock price on the week t-1 for the-ith firm
If devidens are distributed (Dit), the equation is a follows:
- Calculation of weekly market return (Rmt)
Rmt = market return for week t
LQ Index 45t = LQ Index for week t
LQ Index 45t-1 = LQ Index for week t-1
- b) and Stockholders’ Equity Expense
bI = Beta coefficien for stock i
Rit = Return on stock for the-ith firm in week t
Rmt = Market return for week t
In order to calculate stockholders’ equity expense CPAM formula will be used, as follows:
Ri = Stockholders’ equity expense the-ith firm in week t
Rf = Risk free return
RM = Market return
bI = Beta coefficien for stock i
3. Calculation of the Capital Structure
4. Calculation of Annual Weighted Average Cost of Capital (WACC)
WACC = (Debt expense x debt percentage) + (Stockholders’ equity expense xpercentage of stockholders’ equity)
5. Calculation of Annual EVA
EVA = Net earnings after tax – (WACC x capital)
EMPIRICAL EVIDENCES ON EVA
Studies on EVA are limited; moreover, these studies did not come up with similar conclusions. Several studies showed that EVA did not have correlations with stock returns. On the other hand, some studies demonstrated empirical findings that EVA was associated with the returns. By comparing other conventional financial performance, there are also contradictory results. Some research provided evidence that EVA dominated among other financial or operational performance. In contrast to previous findings, other studies showed that EVA did not dominate other financial performance measurement in explaining stock returns.
Biddle, Bowen and Wallace (1997) investigated the claim that EVA was more closely associated with stock returns and firm value than was net income. Based on their analyses, the found that EVA did not dominate net income in associations with stock returns and firm value. Biddle, Bowen, and Wallace (1999) examined evidence regarding the claim that EVA has a stronger association with stock prices and firm values than traditional accounting measures.
Proponents of EVA and other residual income measures have made two principal claims about EVA and/or residual income:
1. They better illustrate stock returns and firm values than traditional accounting earnings.
2. They better motivate managers to create shareholder wealth.
In their recent study, Biddle, Bowen and Wallace (1999) investigated domination of EVA and/or residual income (RI) on earning (net income/NI) and operating cash flow (CFO). Based on their 6,174 sample firms span year 1984-1993, they discovered that current period accounting earnings (NI) is significantly more highly associated with market-adjusted annual stock returns than are RI and EVA, and that all three dominate cash flow from operations. In other words, their results did not support the claim that EVA dominates earnings in its association with stock returns. On the contrary, NI appears to outperform EVA on average.
In addition, Biddle, Bowen and Wallace (1999) investigated whether EVA and/or RI complement currently mandated performance measures by conveying information beyond that embody in concurrent NI and CFO. They decomposed EVA into its component parts and evaluated the contribution of each component toward explaining contemporaneous stock return. They found that EVA components added little explanatory power of the regression. In the other words, EVA components contributed only marginally to the information already available to market participant in NI. Moreover, they found that there is a little incremental information content in EVA, RI, and CFO beyond that contained in NI.
The last problem addressed in their study is related to the claim that EVA dominated earnings in explaining firm values. They found that earnings more often dominated EVA in value-relevance to market participants.
In accordance with the previous study, Hartono and Chendrawati (1999) examined the influence of Economic Value Added (EVA) and Returns on Assets (ROA) on stock returns. Their study was based on two contradictory studies. The first is study of Dodd and Chen. Dodd and Chen, cited by Hartono and Chendrawati (1999), found that a correlation between rate of return on shares and EVA was far from perfect. Also they evidenced that ROA had a closer correlation to the return than EVA did. Moreover, Dodd and Chen also concluded that EVA and ROA had a closer correlation to the return than other financial performance, namely Earning per Share (EPS), Return on Equity (ROE), and so on. In bottom line, the study of Dodd and Chen elucidated that ROA dominated other financial performances toward explaining stock returns.
The other study that became a base of Hartono and Chendrawati’s study was Lehn and Makhija’s findings. Lehn and Makhija concluded that there was a correlation between EVA, ROA, ROE, and rate of return on shares. In contrary to previous study, the second study showed an empirical evidence that EVA had the closest correlation to the return.
Based on two mixture findings above, Hartono and Chendrawati (1999) tried to test the relation between ROA and EVA and the level of return on shares. They hypothesized that ROA and EVA had equal influence with regard to measuring return on shares. In order to test the hypothesis, they used 45 shares included in the LQ 45 Index of Jakarta Stock Exchange for the period July 13, 1994 to the end of 1996. By analyzing the data, their study exhibited evidence that ROA was a better financial performance measurement than EVA was. This result was in line with the results of Dodd and Chen’s study.
Furthermore, based on regression analyses of cross sectional, pooled data, and year-by-year, Hartono and Chendrawati (1999) concluded that EVA was statistically not significant in explaining the rate of return on shares. At the last part of their paper, they acknowledged a limitation of their study due to a short period of the study. Therefore they advocated extending the period of the study.
Unlike the study of Hartono and Chendrawati, Uyemura dkk (1996) demonstrated contradictory end results. They hypothesized that EVA is the most correlated performance measurement to market value added. To test their hypothesis, they used 100 bank holding companies span year 1986 – 1995. They correlated EPS, Net Income, ROE, ROA, and EVA with market value added (MVA). Uyemura dkk (1996) found that EVA had the strongest correlation with MVA compared to other measurements.
In accordance with Uyemura dkk’s conclusion, Grant (1997) also indicated that EVA had a significant impact on the market value of the companies. Using the financial data collected by Stern Stewart & Co., Grant also found that there was a relationship between the MVA-to-capital and EVA-to-capital. His evidences showed that a high EVA-to-capital lead to a high MVA-to-capital, vice versa. These correspondences support a positive relationship between EVA and MVA.
In line with the study of Uyemura dkk, by using Internet companies for the sample, Ho and Li (2000) questioned that it was correct those EVA beaten earnings. They gathered financial data of 240 firms as at June 2000 taken from the Internet and other secondary sources. One of their hypotheses tested in the research was that EVA was a better measure of firm performance than earnings. They found that EVA was a better measure than earnings in the case of Internet companies.
Like other studies on EVA, Bacidore dkk. (1997) concluded that EVA had a positive correlation with abnormal returns. This conclusion was based on a regression of abnormal returns on EVA to determine how well EVA explained abnormal return. In addition, they also investigated the ability of EVA to predict future abnormal returns. The result revealed that EVA had a significant effect on abnormal returns.
Based on the presentation above, it can be concluded that there is no similar finding on the explanatory power of several measurements due to financial performance of companies. Therefore, the study on EVA still can be conducted in order to contribute empirical evidences due to mixed findings on the contribution of EVA with regard to its correlation with stock price.
In terms of practical approach, investors to evaluate the company they invested can use EVA, as an alternative measurement. The suggestion is in line with several studies concluding that EVA has close relationships with the stock price. Other studies stated that EVA better illustrates stock returns and firm values than traditional accounting earnings. Also, EVA better motivates managers to create shareholder wealth. In conclusion, Biddle (1998) stated that whether implementations of EVA has been truly effective in this regard remain an open question for further research.