Does EVA beat earnings?

( Evidence on associations with stock returns and Þrm values)
Gary C. Biddle!,", Robert M. Bowen!,*, James S. Wallace#

Abstract
This study tests assertions that Economic Value Added (EVAt) is more highly
associated with stock returns and Þrm values than accrual earnings, and evaluates which
components of EVA, if any, contribute to these associations. Relative information
content tests reveal earnings to be more highly associated with returns and Þrm values
than EVA, residual income, or cash ßow from operations. Incremental tests suggest that
EVA components add only marginally to information content beyond earnings. Considered
together, these results do not support claims that EVA dominates earnings in
relative information content, and suggest rather that earnings generally outperforms
EVA. ( 1997 Elsevier Science B.V. All rights reserved.

1. Introduction and motivation
For centuries, economists have reasoned that for a Þrm to create wealth it
must earn more than its cost of debt and equity capital (Hamilton, 1777; Marshall, 1890). In the twentieth century, this concept has been operationalized
under various labels including residual income.1 Residual income has been
recommended as an internal measure of business-unit performance (Solomons,
1965) and as an external performance measure for Þnancial reporting (Anthony,
1973, 1982a,b). General Motors applied this concept in the 1920s and General
Electric coined the term Ôresidual incomeÕ in the 1950s and used it to assess the
performance of its decentralized divisions (Stern Stewart EVA Roundtable,
1994).


More recently, Stern Stewart & Company has advocated that a trademarked
variant of residual income, economic value added (EVAt), be used instead of
earnings or cash from operations as a measure of both internal and external
performance.2 They argue: ªAbandon earnings per shareº (Stewart, 1991) (p. 2).
ªEarnings, earnings per share, and earnings growth are misleading measures of
corporate performanceº (Stewart, 1991), (p. 66). ªThe best practical periodic
performance measure is economic value added (EVA)º (Stewart, 1991 (p. 66).
ªForget EPS, ROE and ROI. EVA is what drives stock pricesº (Stern Stewart
advertisement in Harvard Business Review, NovemberÐDecember, 1995, p. 20).
Stewart (1994) cites in-house research indicating that ªEVA stands well out from
the crowd as the single best measure of wealth creation on a contemporaneous
basisº and ªEVA is almost 50% better than its closest accounting-based competitor
in explaining changes in shareholder wealthº (p. 75).


This study provides independent empirical evidence on the information
content of EVA, residual income, and two mandated performance measures,
earnings and cash ßow from operations. Our inquiry is motivated by: the claims
cited above, interest in EVA in the business press, increasing use of EVA by
Þrms, increasing interest in EVA among academics, and potential interest in
EVA among accounting policy makers. Citations of EVA in the business press
have grown exponentially, rising from 1 in 1989 to 294 in 1996 (Lexis/Nexis
ÔallnewsÕ library). Fortune has touted EVA as ªThe Real Key to Creating
Wealthº (30 September 1993), ªA New Way to Find Bargainsº (9 December
1996), and has begun augmenting its well-known Ô500Õ ranking with an annual ÔPerformance 1000Õ based on data from Stern Stewart (Tully, 1993, 1994; Fisher,
1995; Lieber, 1996; Teitelbaum, 1997).