Operating Income, Residual Income and EVA[TM]: Which Metric Is More Value Relevant? [*]

This study empirically examines the value-relevance of three profitability measures: Operating Income (0I), Residual Income (RI), and Economic Value Added (EVA[TM]). [1] Motivation for the research emanates from the popular press's touting of EVA[TM] as the hottest buzzword in Corporate America. As defined by Stem Stewart, EVA[TM] is the difference between a company s net operating income after taxes and its cost of capital of both equity and debt (Stern Stewart, 1993). Three decades of research have found that accounting earnings have information content, but the superiority of EVA[TM] over accounting earnings has only recently been empirically studied. Addressing this question is the main purpose of this study. While the term EVA[TM] appeared as early as 1989 (Finegan, 1989), it received little attention until a September, 1993 article in Fortune magazine (Tully, 1993). The Fortune article provided a detailed description of the EVA[TM] concept, Stern Stewart practice, and successful EVA[TM] adoptions by major corporations in the US. Following the article's kudos of EVA[TM] as the most recent innovation in corporate performance measurement, a flurry of papers were published, primarily in the popular press and practitioner journals, to promote EVA[TM] (e.g., Walbert, 1993; Birchard, 1994; Brossy and Balkcom, 1994; McConville, 1994; Bennett, 1995; Ochsner, 1995; Stewart, 1995; Birchard, 1996; Davies, 1996; Gapenski, 1996; Lehn and Makhija, 1996). As the primary promoter of EVA[TM], Stern Stewart & Company has been the consultant for over 200 companies applying the EVA[TM] paradigm to financial management and incentive compensation (Stern Stewart & Co., 1997). The list of EVA[TM] adopters includes companies such as: Allied Holdings, Briggs & Stratton, Coca Cola, CSX, Dun & Bradstreet, Eli Lilly, Federal-Mogul, Georgia-Pacific, Monsanto, Olin, R.R. Donnelley, Sprint, SPX, Toys R Us, and Whirlpool (Stern Stewart & Co., 1999 web site: http://www.sternstewart.com). Although anecdotal stories may differ in detail among EVA[TM] users, a common theme seems to be that EVA[TM] adoption leads to a dramatic improvement in stock performance. For example, Coca Cola's stock returned about 200% from the inception of EVA[TM] in 1987 to the middle of 1993; similarly, CSX's stock price soared from $28 to $75 between 1988 and 1993 (Tully, 1993). As John Blystone, CEO of SPX Corporation, stated in a Stern Stewart & Co. advertisement, "In the first half of 1996 . . . We have created $135 million in market value for our shareholders, a 67% increase . . ." (Stern Stewart & Co., 1996). Eli Lilly also experienced similar performance; since adopting EVA[TM], its stock price increased 105% in a year (Davies, 1996). EVA[TM]'s purported ability to deliver superior stock returns appears to be its main selling point as evidenced by the following Stern Stewart advertisement: "Forget EPS, ROE and ROI. EVA is what drives stock prices" (Stern Stewart & Co., 1995). Consequently, it is not surprising that the investment community has begun including EVA[TM] in its analyses. As Alfred Jackson, director of global equity research of Credit Suisse First Boston, straightforwardly put it in a recent Stern Stewart & Company advertisement, "At CS First, we use EVA[TM] as our primary equity valuation tool because it works" (Stern Stewart & Co., 1997). "Goldman Sachs is on board too" (Lowenstein, February 13, 1997: C1). It has even been predicted that EVA[TM] will replace Earnings Per Share (EPS) in The Wall Street Journal's regular stock and earnings reports (Zarowin, 1995). Given this rhetoric, it is not surprising that companies are increasingly enticed to the EVA[TM] bandwagon. While successful EVA[TM] stories are quite encouraging, the evidence supporting the rhetoric has been primarily anecdotal. Insufficient empirical research exists to support the claim of EVA[TM]'s supremacy as a performance measure in terms of value-relevance. …