EVA AND CONVENTIONAL CORPORATE PERFORMANCE MEASURES: AN EMPIRICAL STUDY OF INDIAN COMPANIES

Abstract

The past two decades have witnessed a remarkable change in the way businesses run and operate. Increasing complexities in the financial markets along with globalization, technological revolution, ownership concentration patterns and accountability have become the crucial forces for the transformed corporate climate. Today, academics, researchers, business professionals, and stock market analysts widely agree that maximizing shareholder value is the most central financial objective of a business organization. However, usually divergent opinions exist as to how this value can be identified, measured, and ultimately optimized. Companies around the globe are under great pressure not only to adapt to this new climate, but also to perform consistently well in all markets in which they compete. If companies fail to perform, they will either be forced to go bankrupt or will have to face the threat of being taken over by the competitors as happened recently in many advanced markets like USA and Europe. A large number of traditional financial performance measures have been developed to measure the corporate financial performance systems. These measures are often criticized for excluding a firm's cost of capital, and are considered inappropriate to be used when evaluating value creation. Furthermore, it is argued that these measures are based on accounting information, which could be distorted by Generally Accepted Accounting Principles (GAAP). Studies investigating the relationship between these measures and shareholders' value also provide conflicting results. Asa result of the perceived limitations of traditional measures, value based financial performance measures have been developed. The major difference between the traditional and value based measures is that the value based measures include a firm's cost of capital in their calculation. They also attempt to remove some of the accounting distortions resulting from GAAP. EVA is a value based financial performance measure that most accurately reflects company's true profit (Stewart, 1991). EVA is calculated after deducting the cost of equity capital and debt from the operating profits. EVA is a revised version of Residual Income (RI) with a difference the way the Economic Profit and the Economic Capital are calculated. Coined and popularized by New York based management consultancy firm Stern Stewart & Co. in 1991, EVA over the years has gained popularity as a reliable measure of corporate performance. In the later years, the concept has received recognition and support from various corporate houses; those adopted it as an internal control measure. The selling point of EVA is that it considers Economic Profits and Economic Capital in order to know the value created and destroyed by an organization during a particular period. Economic profit and Economic Capital is calculated by making certain adjustments into the accounting profits. Nevertheless, despite the growing amount of literature that has attempted to evaluate the claims made about EVA's superiority, little empirical research has so far been done to support the hypothesis that EVA better explains the firm value as compared to traditional performance measures especially in emerging market like India. Moreover, the limited studies that have appeared in the literature have produced somewhat conflicting conclusions. This conflicting evidence thus necessitates further studies that may provide better insight and understanding into this complex, yet crucial relationship between shareholder wealth creation and EVA. In this thesis, an attempt has been made to examine the efficacy of EVA and conventional corporate performance in Indian market both at aggregate and disaggregate (industry) level and find out which among these measures is a better predicator of firm value in Indian companies. The information content of the traditional measures and the value based measures are evaluated by employing an approach developed by Biddle et al., 1995, 1997; Dodd and Chen, 1997; Chen & Dodd, 2001; Elali, 2006; Ismail, 2006; Erasmus, 2008; Lee and Kim, 2009. The first phase of this approach entails the evaluation of information content of the EVA and traditional performance measures at aggregate level in order to determine which measure explains the largest portion of a contemporaneous MVA. The information content of the components of EVA is then analyzed in order to determine whether component unique to EVA contribute greater than that contained in the other components. The second phase consists of an evaluation of EVA and traditional measures at industry level and ranks these measures in order to find out whether EVA or conventional performance measures is most reliable predicator of MVA. The present study is conducted for 996 Indian non-financial firms listed on the Bombay Stock Exchange for the period 2000 to 2009. The methodology used in the present study is panel data regression model (fixed effects). The results of this study indicate that the value based measure i.e. EVA is not able to outperform traditional measures in the relative information content test. Earnings Per Share (EPS) outperforms EVA in explaining the changes in the MVA of sample companies at aggregate level during 2000-2009. Furthermore, the component analysis of EVA indicates that although the component has some value relevance beyond that of conventional measures vi but the level of significance for these relatively complex adjustments is generally low. Another finding of the study concludes that relatively simple value based measure RI outperforms EVA. It indicates that if a firm intends to incorporate its cost of capital in its financial performance measures, the measure RI provides most of the benefits contained in the other more complex value based measures. Disaggregate analysis indicates that there exists significance difference in the performance of various measures across industries. The majority of the industries are able to create value for shareholders during the study period 2000-2009. Examination of the efficacy of EVA and conventional performance measures indicates that Net Income (NI), Net Operating Profit After Tax (NOPAT) and Cash Flows From Operation (OCF) are top three measures in predicting the changes in the contemporaneous MVA of sample Indian industries during the study period. Thereby concluding that conventional measures are superior to EVA andthe claims made by the proponents of the value based measures cannot be supported. Overall results of the present study refute the claim of EVA superiority in explaining the MVA of Indian companies as compared to traditional measures during 2000-2009. Also relatively low explanatory powers of all the measures examined in the present study suggest that 59% of the variation appears to be attributable to non-earnings based information. Financial measures are only able to explain 41 percent of the variation in the MVA of the Indian companies during the study period. This suggests that if firms desire to more closely align performance measures with firm value, a measurement paradigm other than financial measures will have to be developed and investors must take into consideration non- financial variables such as customer satisfaction, research & development spending, productivity, product quality, employee satisfaction, community satisfaction, information technology and market share growth measuresamong few in corporate valuation.