* Corresponding author. Tel.: (206) 543-4569; fax: (206) 685-9392; e-mail: rbowen@u.

washing-
ton.edu
Journal of Accounting and Economics 24 (1997) 301—336
Does EVA௡ beat earnings?
Evidence on associations with stock returns and
firm values
Gary C. Biddleº', Robert M. Bowenº*, James S. Wallace°
º School of Business Administration, University of Washington, Seattle, WA 98195-3200, USA
' School of Business and Management, Hong Kong University of Science and Technology, Clear Water
Bay, Kowloon, Hong Kong, China
° Graduate School of Management, University of California, Irvine, CA 92697-3125, USA
Received 1 October 1996
Abstract
This study tests assertions that Economic Value Added (EVA௡) is more highly
associated with stock returns and firm 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 firm values
than EVA, residual income, or cash flow from operations. Incremental tests suggest that
EVA components add only marginally to information content beyond earnings. Con-
sidered 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.
JEL classification: M41; G14
Keywords: Value-relevance; Relative information content; Incremental information con-
tent; Firm market value; Economic value added (EVA); Residual income; Economic
profits; Earnings; Cash from operations; Charge for capital
1. Introduction and motivation
For centuries, economists have reasoned that for a firm to create wealth it
must earn more than its cost of debt and equity capital (Hamilton, 1777;
0165-4101/97/$17.00 1997 Elsevier Science B.V. All rights reserved.
PII S 0 1 6 5 - 4 1 0 1 ( 9 8 ) 0 0 0 1 0 - X
¹ Residual income is generally defined as after-tax operating profits less a charge for invested
capital. Operating profits are profits before deducting the after-tax cost of interest expense. The
firm’s weighted average cost of debt and equity capital is deducted in the capital charge. Other labels
include: abnormal earnings (Feltham and Ohlson, 1995); excess earnings (Canning, 1929, Preinreich,
1936, 1937, 1938); excess income (Kay, 1976; Peasnell, 1981, 1982); excess realizable profit (Edwards
and Bell, 1961); and super-profits (Edey, 1957).
` Stern Stewart & Company is a New York-based consulting firm that markets the ‘EVA
Financial Management System’ for internal and external performance measurement and incentive
compensation. Performance measures marketed by competing firms include cash-flow return on
investment (CFROI) by Boston Consulting Group’s HOLT Value Associates, discounted cash-flow
analysis (DCA) by Alcar, discounted economic profits (EP) by Marakon Associates, and economic
value management (EVM) by KPMG Peat Marwick.
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 financial reporting (Anthony,
1973, 1982a,b). General Motors applied this concept in the 1920s and General
Electric coined the term ‘residual income’ 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 (EVA௡), be used instead of
earnings or cash from operations as a measure of both internal and external
performance.` They argue: “Abandon earnings per share” (Stewart, 1991) (p. 2).
“Earnings, earnings per share, and earnings growth are misleading measures of
corporate performance” (Stewart, 1991), (p. 66). “The best practical periodic
performance measure is economic value added (EVA)” (Stewart, 1991 (p. 66).
“Forget EPS, ROE and ROI. EVA is what drives stock prices” (Stern Stewart
advertisement in Harvard Business Review, November—December, 1995, p. 20).
Stewart (1994) cites in-house research indicating that “EVA stands well out from
the crowd as the single best measure of wealth creation on a contemporaneous
basis” and “EVA is almost 50% better than its closest accounting-based com-
petitor in explaining changes in shareholder wealth” (p. 75).
This study provides independent empirical evidence on the information
content of EVA, residual income, and two mandated performance measures,
earnings and cash flow from operations. Our inquiry is motivated by: the claims
cited above, interest in EVA in the business press, increasing use of EVA by
firms, 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
‘allnews’ library). Fortune has touted EVA as “The Real Key to Creating
Wealth” (30 September 1993), “A New Way to Find Bargains” (9 December
1996), and has begun augmenting its well-known ‘500’ ranking with an annual
302 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
` CFO Basil Anderson of Scott Paper states: ‘‘We used to have different financial measures for
different purposes — discounted cash flow for capital decisions, another measure for rewarding
performance and the like.
2
Now EVA is one measure that integrates all that.
2
it offers an
excellent link to the creation of shareholder value’’ (Walbert, 1994) pp. 111—112. Jim Meenan, CFO
of AT&T’s communications services group expresses a similar view: ‘‘Every decision is now based on
EVA. The motivation of our business units is no longer just to make a profit. The drive is to earn the
cost of capital.
2
when you drive your business units toward EVA, you’re really driving the
correlation with market value’’ (Walbert, 1994) (p. 112). Eugene Vesell, managing director of
Oppenheimer Capital states: ‘‘The first thing we look at when we pick companies is, are they
motivated by EVA? We prefer it to measures like EPS or return on equity.’’ (Tully, 1994) (p. 143).
" We emphasize that our results are only an input to the policy making process. Each of the
measures we consider may have value in other decision contexts, e.g., cash from operations may
provide valuable information to lenders and suppliers about liquidity. Questions regarding cost and
best source(s) of data are beyond the scope of this research.
‘Performance 1000’ based on data from Stern Stewart (Tully, 1993, 1994; Fisher,
1995; Lieber, 1996; Teitelbaum, 1997).
Companies that have adopted EVA for performance measurement and/or
incentive compensation include AT&T, Coca Cola, Eli Lilly, Georgia Pacific,
Polaroid, Quaker Oats, Sprint, Teledyne and Tenneco. The ‘EVA Financial
Management System’ is alleged to encourage managers to act more like owners
by helping managers make improved operating, financing and investment
decisions.` Evidence provided in Wallace (1997) suggests that managers com-
pensated on the basis of EVA (instead of earnings) take actions consistent with
EVA-based incentives.
Recently, academics have shown interest in models of equity valuation that
express firm value in terms of book value and the expected stream of residual
income or ‘abnormal earnings’ (Ohlson, 1995; Feltham and Ohlson, 1995). Our
study provides empirical evidence on whether current period realizations of
residual income (RI) and EVA are more closely associated with stock returns
than are traditional accounting measures such as earnings and cash from
operations (CFO).
Finally, data on the information content of EVA and RI provide potentially
useful input to the normative policy debate on what performance measure(s)
should be reported in financial statements." Financial reporting has been
criticized for low-quality and lack of relevance in today’s information-rich
environment. The AICPA Special Committee on Financial Reporting (1994),
the Jenkins Committee, makes suggestions for improving financial reporting
that are consistent with firms using EVA for internal decision making and
external reporting. A prediction from an April 1995 AICPA workshop on the
future of financial management is that EVA will replace EPS in ¹he ¼all Street
Journal’s regular stock and earnings reports (Zarowin, 1995) (p. 48). Widespread
interest in revisiting the quality of financial reporting suggests that altern-
atives to currently mandated performance measures should be evaluated for
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 303
value-relevance. This study provides evidence that we hope will be useful to
policy makers who may be interested in EVA or RI as replacements (or
complements) to earnings and CFO as key measures of firm performance.
The first (of two) empirical questions we address is
Q1: Do EVA and/or RI dominate currently mandated performance
measures, earnings and operating cash flow, in explaining contempor-
aneous annual stock returns?
This relative information content question examines which variables (EVA, RI,
CFO or earnings) have a greater association with contemporaneous stock
returns and provides a direct test of one of Stern Stewart’s claims about the
superiority of EVA. (In Section 5.5 we examine separately another Stern Stewart
claim that EVA outperforms earnings in explaining firm values.) Using a sample
of 6,174 firm-years representing both adopters and non-adopters of EVA over
the period 1984—1993, tests of question 1 indicate that earnings (R`"12.8%) is
significantly more highly associated with market-adjusted annual returns than
are RI (R`"7.3%) or EVA (R`"6.5%) and that all three of these measures
dominate CFO (R`"2.8%). This finding is supported across a number of
alternative specifications.
Second, we examine whether EVA and/or RI complement currently mandated
performance measures, earnings and CFO:
Q2: Do components unique to EVA and/or RI help explain contempor-
aneous stock returns beyond that explained by CFO and earnings?
This is equivalent to asking: Does the market appear to value a given EVA
component beyond the information contained in the other components? To
address this incremental information content question, we decompose EVA into
components (e.g., cash from operations, operating accruals, capital charge, and
accounting ‘adjustments’) and evaluate the contribution of each component
toward explaining contemporaneous stock returns. For the full sample, while
each component is significantly associated with market-adjusted returns, the
EVA components do not appear to be economically significant. Further, tests
across alternative specifications indicate that, while cash flow and accrual
components are consistently significant, components unique to EVA (capital
charge and accounting adjustments) are typically not significant. Considering
the relative and incremental information content results together, neither EVA
nor RI appears to dominate earnings in its association with stock market
returns.
The remainder of the paper is organized as follows. Section 2 provides
a description of EVA and its components, presents hypotheses, and describes
statistical tests for relative and incremental information content. Section 3
304 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
reports sample selection criteria, variable definitions, and descriptive statistics.
Section 4 provides empirical results on the relative and incremental information
content of EVA and its components. Section 5 reports various extensions and
sensitivity analyses. We close with a summary and a discussion of potential
factors contributing to the failure of EVA and/or RI to dominate earnings.
2. Components of EVA, hypotheses and statistical tests
2.1. Linkages between operating cash flow, earnings, residual income and E»A
This section describes linkages between operating cash flows (CFO), earnings
before extraordinary items (EBEI), residual income (RI) and economic value
added (EVA). We begin by partitioning earnings into operating cash flows and
accruals:
EBEI"CFO#Accrual,
where
CFO "net cash provided by operating activities.
Accrual "total accruals related to operating (as opposed to investing or
financing) activities, e.g., depreciation, amortization, non-cash
current assets, current liabilities (other than notes payable and
current portion of long-term debt), and non-current portion of
deferred taxes.
Next, we define net operating profits after tax (NOPAT) as EBEI plus the
after-tax cost of interest expense
NOPAT"EBEI#ATInt,
where
ATInt"the after-tax equivalent of book interest expense.
NOPAT separates operating activities from financing activities by adding back
the after-tax effect of debt financing charges (interest expense) included in EBEI.
Residual income differs from EBEI in that it measures operating performance
(NOPAT) net of a charge for the cost of all debt and equity capital employed:
RI"NOPAT!(k
*
Capital),
where
k "Stern Stewart’s estimate of the firm’s weighted average cost of
capital.
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 305
` Other adjustments to NOPAT include: adding the change in bad debt allowances; adding the
change in the LIFO reserve; adding goodwill amortization; adding other operating income; and
subtracting an estimate of taxes owed for the period (Stewart, 1991) (pp. 742—743). Stern Stewart do
not disclose complete details about their accounting adjustments, e.g., asset lives and amortization
patterns.
" Other adjustments to Capital include: capitalization and amortization of certain marketing
costs; subtracting marketable securities and construction in progress (because neither contributes to
current operating activities); adding the present value of non-capitalized long term leases; adding
allowances for bad debts, inventory obsolescence, warranties, etc.; adding the LIFO reserve; adding
net capitalized intangibles (including R&D); adding cumulative goodwill amortization; adding
unrecorded goodwill; and adding (subtracting) cumulative unusual losses (gains), net of taxes
(Stewart, 1991) (pp. 112—117). AcctAdj
ºº
and AcctAdj
°
are not examined individually in subsequent
empirical tests because Stern Stewart does not disclose them separately.
Capital "Stern Stewart’s definition of assets (net of depreciation) invested in
going-concern operating activities, or equivalently, contributed and
retained debt and equity capital, at the beginning of the period.
Positive RI reflects profits in excess of that required by debt and equity capital
suppliers and, thus, is consistent with the firm creating wealth for the residual
claimants, the shareholders. Negative RI is consistent with decreasing share-
holder wealth.
EVA is Stern Stewart’s proprietary version of RI. Stern Stewart attempts to
improve on RI by adjusting NOPAT and Capital for what they view to be
‘distortions’ in the accounting model of performance measurement (Stewart,
1991) (Chapter 2):
EVA"NOPAT#AcctAdj
ºº
!k
*
[Capital#AcctAdj
°
],
where
AcctAdj
ºº
"Stern Stewart adjustments to accounting measures of operating
profits.
AcctAdj
°
"Stern Stewart adjustments to accounting measures of capital.
As an example of a common accounting adjustment, Stewart (1991) (pp. 28—30)
argues that research and development costs should be capitalized (if material)
and amortized. This requires adjustments to both NOPAT (via AcctAdj
ºº
)
and to Capital (via AcctAdj
°
). NOPAT is adjusted by adding back the period’s
R&D expense and deducting amortization of the R&D asset.` In any given
year, the net effect is an increase (decrease) in NOPAT if R&D expense is greater
(less) than R&D amortization. AcctAdj
°
reflect the cumulative effect on Capital
of the capitalization and amortization of current and past R&D expenditures.
At any point in time, Capital is higher by the amount of the net capitalized
R&D asset."
306 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
Fig. 1. Components of economic value added (EVA).
Relying on the above definitions, EVAcan be decomposed into its component
parts:
EVA"CFO#Accrual#ATInt!CapChg#AcctAdj,
where
CapChg"k
*
Capital
AcctAdj"AcctAdj
ºº
!(k
*
AcctAdj
°
).
Fig. 1 summarizes these relations by showing how EVA components combine
into other performance measures, i.e., CFO, EBEI and RI. We use this
decomposition to examine the incremental information content of EVA
components.
2.2. Hypotheses
By assuming that equity markets are (semi-strong) efficient, forward-looking
and can form estimates of performance measures, we use stock market returns
to compare the information content, or value-relevance, of CFO, EBEI, RI
and EVA. Following Biddle et al., 1995, we draw a distinction between
relative and incremental information content. Relative information content
comparisons are appropriate when one desires a ranking of performance
measures by information content or when making mutually exclusive choices
among performance measures, i.e., when only one measure can be chosen. In
contrast, incremental information content comparisons assess whether one
measure provides value-relevant data beyond that provided by another
measure and apply when assessing the information content of a supplemental
disclosure or the information of a component measure (e.g., Bowen et al.,
1987).
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 307
` The MVEdeflator is measured 3 months after the prior year end to be consistent with the start of
the returns period measured by the dependent variable.
Despite claims by Stern Stewart and others that EVA and RI are more
value-relevant to market participants than EBEI and CFO, we take a neutral
position and conduct two-tail tests of the null hypotheses that CFO, EBEI, RI
and EVA have equal relative information content:
H
"
: The information content of measure X
¹
is equal to that of X
`
where X
¹
and X
`
represent pairwise combinations from the set of performance
measures: CFO, EBEI, RI and EVA. Rejection of H
"
is viewed as evidence of
a significant difference in relative information content.
We examine the incremental value relevance of EVA components sum-
marized in Fig. 1 by testing the null hypotheses that individual components of
EVA do not provide incremental information content beyond other compo-
nents that also comprise CFO and EBEI:
H
'
: Component X
¹
does not provide information content beyond that pro-
vided by the remaining components X
`
—X
`
where X
¹
—X
`
are components of EVA (i.e., CFO, Accrual, ATInt, CapChg and
AcctAdj). Rejection of H
'
is viewed as evidence of incremental information
content.
2.3. Statistical tests
A standard approach for assessing information content is to examine the
statistical significance of the slope coefficient, b
¹
, in the following ordinary-
least-squares regression (that omits firm subscripts):
D
R
"b
"
#b
¹
FE
6R
/MVE

#e
R
(1)
where, D
R
is the dependent variable, a measure of (abnormal or unexpected)
returns for time period t; FE
6R
/MVE

is the unexpected realization (or forecast
error) for a given accounting measure, X (e.g., CFO, EBEI, RI or EVA), scaled
by the beginning-of-period market value of the firm’s equity, MVE

,` and e
R
is
a random disturbance term.
Because little is known about suitable proxies for market expectations for
performance measures other than earnings, we use an approach from Biddle and
308 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
` We also consider a specification that allows each information variable to be predicted by lagged
observations of all of the information variables. Thus each information variable, say EVA, is
predicted by lagged values of each of the other variables — CFO, EBEI, RI and EVA. This is one way
of addressing the potential concern that (say) EVA is less well predicted by past observations of EVA
than (say) EBEI is predicted by past values of EBEI. Results based on these specifications are
qualitatively similar to those reported and are available from the authors.
Seow (1991) and Biddle et al., 1995 that estimates market expectations ‘jointly’
with slope coefficients. This is accomplished by first expressing the forecast error
as the difference between the realized value of a performance measure and the
market’s expectation: FE
R
"X
R
!E(X
R
). It is then assumed that market expecta-
tions are formed according to a discrete linear stochastic process (in autoregres-
sive form):
E(X
R
)"#
¹
X

#
`
X
R`
#
`
X
R`
#
2
(2)
where the is a constant and ’s are autoregressive parameters. Substituting
Eq. (2) into Eq. (1) yields:
D
R
"b
"
#b
¹
(X
R
!(#
¹
X

#
`
X
R`
#
`
X
R`
#
2
))/MVE

#e
R
"b
"
#b
¹
X
R
/MVE

#b
`
X

/MVE

#b
`
X
R`
/MVE

#b
"
X
R`
/MVE

#
2
#e
R
. (3)
Eq. (3) relates abnormal returns and (scaled) lagged measures of accounting
performance, where E(b
"
)"b
"
!b
¹
, E(b
¹
)"b
¹
, and E(b
G
)"!b
G


for
i'1. In Eq. (3), the proxy for market expectations is estimated jointly with the
slope coefficient (b
G
) using the same data and optimization criterion (minimum
mean squared errors).
Eq. (3) encompasses a range of alternative specifications for market expecta-
tions, including random-walk, ARIMA, constant stock price multiple, and
combined ‘levels and changes’ specifications. Although Eq. (3) is flexible in terms
of allowing any number of lagged observations to be included as explanatory
variables, in the presence of possible structural change across time, we limit
Eq. (3) to one lag:`
D
R
"b
"
#b
¹
X
R
/MVE

#b
`
X

/MVE

#e
R
. (4)
This ‘one-lag’ version is equivalent to the ‘levels and changes’ specification
proposed by Easton and Harris (1991), but it is motivated differently. It also is in
a more convenient form that allows the slope or ‘response’ coefficient (b
¹
) to be
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 309
" The relation between the two specifications can be illustrated by starting with the levels-changes
specification (in Eq. (4a)) and deriving the one-lag specification (in Eq. (4c)):
D
R
"a
"
#a
¹
X
R
/MVE

#a
`
(X
R
!X

)/MVE

#e
R
(4a)
"a
"
#a
¹
X
R
/MVE

#a
`
X
R
/MVE

!a
`
X

/MVE

#e
R
(4b)
"a
"
#(a
¹
#a
`
)X
R
/MVE

!a
`
X

/MVE

#e
R
. (4c)
Eq. (4c) corresponds to Eq. (4) where b
¹
"a
¹
#a
`
and b
`
"!a
`
. Since a
¹
and a
`
are both
expected to be positive, b
¹
(b
`
) is predicted to be positive (negative). The coefficient(s) on the non-lag
term(s) can be interpreted directly as ‘response’ coefficient(s), e.g., in Eq. (4c) the response coefficient
is (a
¹
#a
`
).
¹" The Biddle—Seow—Siegel test derives from Hotelling (1940). By using a lack-of-fit measure
defined as the average of the sum of squared residuals and the sum of squared prediction errors,
a nonlinear null hypothesis is obtained that involves quadratic forms of regression coefficients. It is
tested using a Wald test (Kennedy, 1985) of estimated coefficients and their heteroskedasticity-
adjusted variance—covariance matrix. As discussed in Biddle et al. (1995), this method for assessing
relative information content compares favorably with alternative tests provided in Davidson
and MacKinnon (1981) and Vuong (1989). Davidson and MacKinnon’s non-nested ‘J-test’ and
Vuong’s likelihood ratio test are ‘pairwise tests for model selection’ designed to assess which of
two competing models is closer (in terms of Kullback-Liebler distance) to the ‘truth’. Both are
valid only asymptotically and may have poor finite sample properties. The J-test also can yield
ambiguous results, which is problematic in applications assessing relative information content.
Dechow, Lys and Sabino (1996) provide evidence that Vuong’s test outperforms the J-test. Biddle
and Siegel (1996) provide evidence that the Biddle—Seow—Siegel test performs as well as or better
than Vuong’s test in calibration and power. As confirming evidence, we replicated our relative
information content tests using Vuong’s test with qualitatively similar results as discussed briefly
in Section 4 below.
observed directly (rather than being derived from separate coefficients on levels
and changes)."
2.3.1. Tests for relative information content
To assess relative information content, we employ a statistical test from
Biddle et al. (1995) that allows a test of the null hypothesis of no difference in the
ability of two competing sets of independent variables to explain variation in the
dependent variable. Using this test, we make six pairwise comparisons of
regressions among the accounting performance measures CFO, EBEI, RI and
EVA, as specified in Eq. (4). The test is constructed as a comparison of R`s.
Under usual regularity conditions (uncorrelated homoskedastic errors), it is
finite sample exact, generalizes to any number of predictor variables, and can be
used in conjunction with White’s (1980) correction for heteroskedastic errors. As
a result, it is well suited to evaluate the significance of relative information
content comparisons in accounting contexts.¹"
310 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
¹¹ For their publicly available database used in this study, Stern Stewart make ‘a handful’ of
standard adjustments. For their corporate clients, Stern Stewart make additional custom adjust-
ments (not available to the public).
¹` In other words, data greater (less) than 4 standard deviations from the median of the firm-year
observations are assigned a value equal to the median plus (minus) 4 standard deviations. The total
number of observations reset for any variable range from 51 to 97, or 0.83% to 1.57% of the 6,174
sample firm years.
2.3.2. Tests for incremental information content
Following standard methodology (e.g., Bowen et al. (1987)), incremental
information content is assessed by examining the statistical significance of
regression slope coefficients. Specifically, for the one-lag specification in Eq. (4)
generalized to two accounting performance measures X and ½, incremental
information content is assessed using t-tests on individual coefficients and
F-tests of the joint null hypotheses:
H
"6
: b
¹
"b
`
"0,
H
"7
: b
`
"b
"
"0,
where b
¹
, b
`
, b
`
and b
"
are from Eq. (5) below:
D
R
"b
"
#b
¹
X
R
/MVE

#b
`
X

/MVE

#b
`
½
R
/MVE

#b
"
½

/MVE

#e
R
. (5)
To control for the potential effects of heteroskedastic errors, White’s (1980)
correction is employed in both the relative and incremental information content
tests.
3. Sample selection, variable definitions and descriptive statistics
3.1. Sample selection
Data used in this study were purchased directly from Stern Stewart & Co.¹¹
These data include up to eleven annual observations for economic value added
(EVA), capital, and cost of capital for firms with fiscal years ending June 1983 to
May 1994 (see variable definitions below). The initial sample of 1000 firms (8,524
firm-year observations) is reduced by 219 firms (2,271 observations) due to
either missing Compustat or CRSP (Center for Research in Securities Prices)
data or to provide a lagged observation for each variable. We also delete 79
extreme outlier observations defined as more than 8 standard deviations from
the median. Next, both the dependent and independent variables are winsorized
to $4 standard deviations from the median.¹` The resulting sample has 6,174
firm-year observations for 773 firms.
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 311
¹` Consistent with the possibility that pre-1988 measures of CFO are noisy, R`s in two-year
sub-periods from 1988 onward are slightly higher than for the two, two-year sub-periods before
1988.
These data are compiled by Stern Stewart & Company from Business ¼eek’s
listing of the 1,000 largest firms in market capitalization. Stern Stewart modifies
this list by first removing utilities and financial institutions, and then adding
firms from prior Business ¼eek 1000 listings to bring the sample back to 1,000
firms. Stern Stewart introduced its first 1000 ranking for the calendar year ended
1988. The listing is published annually.
3.2. Dependent variable
Our dependent variable, market adjusted returns, is commonly used in
information content studies to measure unexpected returns (e.g., Biddle et al.,
1995; Bowen et al., 1989).
MktAdjRet Market adjusted return computed from CRSP data as a firm’s
12-month compounded stock return less the 12-month com-
pounded value-weighted market-wide return. A 12-month non-
overlapping period ending three months following the firm’s fiscal
year-end is chosen to allow time for information contained in the
firm’s annual report to be impounded in stock market prices.
3.3. Independent variables and descriptive data — relative information content tests
The four measures of accounting performance in the relative information
content tests, CFO, EBEI, RI and EVA, are defined below:
CFO Cash flow from operations obtained from the statement of cash
flows or the statement of changes in financial position, depending
upon the year of the observation. For years after 1987 Compustat
data item D308, operating activities — net cash flow, is used. For
years prior to 1988, data item D110, funds from operations
— total, is used if the firm used the cash definition of funds for the
statement of changes in financial position. If the firm used the
working capital definition of funds in any year prior to 1988, cash
flow from operations is estimated similar to Bowen et al. (1986,
1987) as funds from operations (D110) plus the change in current
liabilities (D5) less the change in debt in current liabilities (D34)
less the change in current assets (D4) plus the change in cash and
cash equivalents (D1).¹`
312 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
EBEI Earnings defined as Compustat data item D18, net income before
extraordinary items.
RI Residual income equals earnings plus after-tax interest expense
less a charge on all capital (RI"EBEI#ATInt!CapChg). See
Section 3.4 below for definitions of ATInt and CapChg.
EVA Economic value added obtained from the Stern Stewart 1000
database.
In order to reduce heteroscedasticity in the data, we deflate all independent
variables by the market value of equity three months after the beginning of the
fiscal year (MVE

). Descriptive data on these deflated, winsorized variables
pooled across time are provided in Panel A of Table 1. EBEI has the lowest
standard deviation among the four performance measures consistent with the
smoothing effects of accruals. CFO has the largest firm-year mean and median
followed by EBEI, EVA and RI. Undeflated median values of each performance
measure are plotted across time in Fig. 2. Despite a survivorship bias in the
data, median RI is negative in every year and median EVA is negative in 7 out of
10 years. Near zero EVA and RI is consistent with a competitive economy where
even the typical large firm has difficulty earning more than its cost of capital.
Low values of EVA and RI are also consistent with a potential upward bias in
Stern Stewart’s cost of capital estimates.
Correlations among these measures are provided in Panel A of Table 1.
Correlations between the independent variables are all positive and significant
except that EVA and RI are negatively correlated with CFO. EBEI has the
highest correlation with market adjusted returns.
3.4. Independent variables and descriptive data — incremental information
content tests
The independent variables in the incremental information content tests are
the five components of EVA described in Section 2.1 and summarized in Fig. 1:
CFO (defined above), operating accruals, after-tax interest expense, capital
charge and accounting adjustments:
Accrual Operating accruals defined as earnings less cash flow from opera-
tions (Accruals"EBEI!CFO). Accruals can be positive or nega-
tive but are more likely to be negative (reflecting non-cash expenses
such as depreciation and amortization).
ATInt After tax interest expense computed as 1 minus the firm’s tax rate
multiplied by interest expense (D15). The firm’s tax rate is assumed
to be zero if net operating losses are present. Otherwise the max-
imumstatutory corporate tax rate is used for the given year. ATInt is
non-negative.
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 313
Table 1
Descriptive statistics for pooled data
Panel A: Descriptive statistics on the dependent and independent variable in relative information
content testsº
Dependent
variable Independent variables
MktAdjRet
'
EBEI
R
EVA
R
RI
R
CFO
R
Descriptive statistics
Mean 0.059 0.057 !0.049 !0.056 0.142
Median 0.011 !0.065 !0.007 !0.017 0.118
Std. Dev. 0.362 0.082 0.134 0.127 0.133
Correlations'
MktAdjRet
'
1.00
EBEI
R
0.247 1.00
EVA
R
0.153 0.592 1.00
RI
R
0.155 0.652 0.900 0.900
CFO
R
0.138 0.307 !0.125 !0.122 1.00
Panel B: Descriptive statistics on the dependent and independent variable in incremental information
content testsº
Dependent
variable Independent variables
MktAdjRet
'
CFO
R
Accrual
R
ATInt
R
CapChg
R
AccAdj
R
Descriptive statistics
Mean 0.059 0.142 !0.086 0.034 0.149 !0.007
Median 0.011 0.118 !0.055 0.016 0.111 !0.007
Std. Dev. 0.362 0.133 0.137 0.054 0.129 0.055
Correlations'
MktAdjRet
'
1.00
CFO
R
0.138 1.00
Accrual
R
0.021 !0.782 1.00
ATInt
R
!0.026 0.363 !0.501 1.00
CapChg
R
!0.018 0.469 !0.580 0.751 1.00
AccAdj
R
!0.011 0.004 0.039 0.210 0.057 1.00
ºThe sample has 6,174 firm-year observations. All variables are winsorized $4 standard deviations
from the median. All independent variables are deflated by the market value of equity three months
after the beginning of the fiscal year.
'Pearson correlation coefficients '0.0204 are significant at (0.10
'0.0319 are significant at (0.01
'0.0407 are significant at (0.001
314 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
Fig. 2. Median values of performance measures, 1984—93.
¹" According to Stewart (1994), Stern Stewart estimate the cost of capital by weighting the cost of
equity (applying the capital asset pricing model) and the after-tax cost of debt. Capital is a proxy for all
cash invested in the business since a company’s inception. See Stewart (1991), especially pp. 741—745.
¹` Our definition of RI incorporates Stern Stewart adjustments to capital. Data were not available
from Stern Stewart to calculate capital before accounting adjustments.
CapChg Capital charge defined as the firm’s weighted average cost of debt
and equity capital times its beginning of year capital.¹" Both of these
items are obtained from Stern Stewart. CapChg is positive since both
the cost of capital and capital are positive.
AcctAdj Accounting adjustments reflect Stern Stewart’s net annual adjust-
ments to earnings and capital, and are defined as economic value
added less residual income (AcctAdj"EVA!RI).¹` AcctAdj can be
positive or negative.
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 315
¹" On average, we predict a positive (negative) slope coefficient on contemporaneous (lagged)
observations of each performance measure. The negative coefficient on the lagged term follows from
the prediction that changes in the performance measures also are positively associated with stock
returns (see Section 2.3, especially footnote 9). In results available from the authors, coefficient
b
¹
(b
`
) is positive (negative) and significant (at (0.00001) for each performance measure based on
the full sample of 6,174 firm-years.
¹` Nearly identical inferences are obtained using the Vuong (1989) test. For example, for the
relative comparisons in Panel A of Table 2 and Table 4, identical inferences are obtained at
conventional significance levels for all pairwise comparisons. In general, the Vuong test provides
greater statistical significance, consistent with its asymptotic nature and tendency to reject the null
observed in simulation tests (Biddle and Siegel, 1996).
Descriptive data on these deflated, winsorized EVA components are provided
in panel B of Table 1. CFO has by far the largest correlation with market-adjusted
returns. Both mean and median Accrual and AcctAdj are negative, consistent
with some smoothing of the underlying operating cash flows. Correlations be-
tween CFO, ATInt and CapChg are positive and significant, consistent with firms
with higher operating cash flows also having higher debt and equity costs. The
negative correlation between CFO and Accrual is again consistent with the
accrual process smoothing earnings relative to the underlying operating cash
flows. The correlation between CFO and AcctAdj is insignificant.
4. Empirical results
4.1. Relative information content tests
Relative information content is assessed by comparing adjusted R`s from four
separate regressions, one for each performance measure, CFO, EBEI, RI and
EVA.¹" Adjusted R`s from these regressions are provided in Table 2. The
highest R` is shown on the left (which in both panels is from the EBEI
regression) and the lowest is shown on the far right (which in both panels is from
the CFO regression). p-values from two-tailed statistical tests of relative in-
formation content are shown centered in parentheses for each of the six possible
pairwise comparisons.
Results in Panel A of Table 2 are based on Eq. (4) and each of the six pairwise
differences in R` are significant at conventional levels, with EBEI having
a significantly larger adjusted R` (9%) than each of the other three performance
measures. The RI regression has a significantly larger adjusted R` (6.2%) than
does the EVA regression (5.1%), and both have a significantly larger adjusted
R`s than CFO (2.4%). These results suggest that, in terms of relative informa-
tion content, earnings significantly outperforms RI, RI significantly outperforms
EVA (although the gap here is smaller), and all three outperform CFO.¹`
316 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
Table 2
Tests of the relative information content of EVA௡, residual income, earnings and operating cash flow
(H
"
)
Relative information content
Rank order Observa-
of R` tions (1) (2) (3) (4)
Panel A: Coefficient of positive and negative values of each performance measure constrained to be
equalº
All firms 6,174 EBEI ' RI ' EVA ' CFO
Adj. R` 0.0904 0.0624 0.0507 0.0238
p-value' (0.000) (0.041) (0.000)
(0.000) (0.000)
(0.000)
Panel B: Coefficient of positive and negative values of each performance measure allowed to differ°
All firms 6,174 EBEI ' RI ' EVA ' CFO
Adj. R` 0.1278 0.0732 0.0649 0.0280
p-value' (0.000) (0.266) (0.000)
(0.000) (0.000)
(0.000)
ºUnderlying regressions are from Eq. (4): D
R
"b
"
#b
¹
X
R
/MVE

#b
`
X

/MVE

#e
R
, where
D
R
"market-adjusted returns; X"a given performance measure (CFO, EBEI, RI and EVA); and
MVE"the market value of equity three months after the beginning of the fiscal year. Performance
metrics are listed in order of R-squares from highest (on the left) to lowest (on the right). Statistical
tests of differences in explanatory power across performance measures are presented centered in
parantheses below the adjusted R-squares. See description of p-value below.
'Two-tailed p-values in parentheses represent tests of the null hypothesis of no difference between
pairwise comparisons of adjusted R-squares (Biddle et al., 1995). First row presents p-value for
comparison between first and second ranked measures, second and third ranked measures and third
and fourth ranked measures. On the the next row, comparisons are between first and third ranked,
and second and fourth ranked measures. The last row compares first and fourth ranked measures.
°Underlying regressions are from Eq. (4) modified to allow different coefficients on positive versus
negative values of the independent variables:
D
R
"b
"
#b
¹
X
Rºº'
/MVE

#b
`
X
R"°¨
/MVE

#b
`
X
R¹ºº'
/MVE

#b
"
X
R¹"°¨
/MVE

#e
R
(6)
where D
R
"market-adjusted returns; X"a given performance measure (CFO, EBEI, RI or EVA);
and MVE"market value of equity three months after the beginning of the fiscal year.
The underlying regressions in panel A constrain the coefficients to be equal
across all firm-year observations. Hayn (1995), Burgstahler and Dichev (1997)
and Collins et al. (1997) provide evidence that loss firms have smaller earnings
response coefficients than do profitable firms. Because the value-relevance of the
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 317
other performance measures (CFO, RI and EVA) could also vary with their sign
(O’Byrne, 1996), we repeat our tests for relative information content after
partitioning each performance measure into positive and negative values:
MktAdjRet
R
"b
"
#b
¹
X
Rºº'
/MVE

#b
`
X
R"°¨
/MVE

#b
`
X
R¹ºº'
/MVE

#b
"
X
R¹"°¨
/MVE

#e
R
. (6)
Panel B of Table 2 presents results for regression (6) for the complete sample
of 6,174 firm-year observations. Consistent with prior research, coefficients
(available from the authors) are generally larger (in absolute value) and more
significant for positive values of X
R
than for the negative values. Compared to
results reported above in Panel A, adjusted R`s increase for each performance
measure when allowing for separate coefficients on positive and negative values.
This increase is largest for the EBEI regression with adjusted R` increasing from
9% to 12.8%. However, the ranking of performance measures remains identical
and statistical comparisons between regressions are nearly unchanged — earn-
ings dominates each of the other three performance measures and all three
(EBEI, RI and EVA) dominate CFO. The only difference is that RI and EVA are
no longer statistically different from each other.
Taken as a whole, the relative information content results show no evidence of
EVA(RI or CFO) dominating EBEI. Thus, we cannot support the Stern Stewart
claim that EVA has greater information content than earnings. In contrast, this
evidence points to earnings having higher relative information content than
EVA. In Section 5, we examine the sensitivity of these results to alternative
specifications. In Section 6, we discuss possible reasons why we fail to detect
stronger value-relevance for EVA and RI.
4.2. Incremental information content tests
Table 3 presents results on the incremental information content of EVA
components from regression (7):
MktAdjRet
R
"b
"
#b
¹
CFO
R
#b
`
CFO

#b
`
Accrual
R
#b
"
Accrual

#b
`
ATInt
R
#b
"
ATInt

#b
`
CapChg
R
#b
`
CapChg

#b
"
AcctAdj
R
#b
¹"
AcctAdj

#e
R
. (7)
Predicted signs on each coefficient are provided below the variable labels. We
expect a positive association between market-adjusted returns and the three
components CFO, Accrual and AcctAdj. We expect a negative association be-
tween returns and the two components representing non-negative capital costs,
ATInt and CapChg. Similar to the relative information content regressions in
Eq. (4), the lagged terms are predicted to have the opposite sign (footnote 9).
318 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
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G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 319
Fig. 3. Relative and incremental information content of EVA௡, residual income, earnings and
operating cash flow.
In Panel A for the full sample, 9 out of 10 coefficients are in the predicted
direction and significant in one-tail t-tests at the 0.05 level or better. The
exception is the lagged term for AcctAdj, which is in the wrong direction. All of
the two-tail F-tests are significant at the 0.05 level or better. The relative sizes of
the F-statistics suggest that CFO and Accrual make by far the largest incre-
mental contributions to explaining market-adjusted returns, while ATInt,
CapChg and AcctAdj exhibit much smaller incremental contributions. When
combined with the relative information content findings above, these results
suggest that, while EVA components offer some incremental information con-
tent beyond earnings components, their contributions to the information con-
tent of EVA are not sufficient for EVA to provide greater relative information
content than earnings.
Fig. 3 uses a Venn diagram to summarize our findings on relative and
incremental information content for the four information variables CFO, EBEI,
RI and EVA. The size of each circle represents relative information content and
the non-overlapping areas represent incremental information content. EBEI
exhibits the largest relative information content among the measures. CFO, RI
and EVA protrude slightly from behind EBEI reflecting some limited incremen-
tal information content beyond earnings. However, the overall minuscule in-
crease in adjusted R` between the regression of returns on EBEI (9.04% in Panel
A of Table 2) and returns on EVA components (9.07% in Table 3) suggests that
the economic significance of the incremental information content of the EVA
components is slight.
320 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
5. Sensitivity analyses and extensions
In this section, we examine the sensitivity of the basic results reported above
to alternative specifications. We repeat selected information content tests by:
1) partitioning annual observations into five, non-overlapping, two-year test
periods (instead of one ten-year period); 2) evaluating subsets of firms that claim
to use EVA for internal business decisions; 3) changing the return interval from
one-year to five-years; and 4) changing the return interval from one-year
(contemporaneous) returns to two-year (combined contemporaneous and one-
year ahead) returns. Finally, we discuss a replication and extension of O’Byrne
(1996), where the dependent variable is the level of market value of the firm
(rather than returns). We conclude with an overall assessment of the results of
the sensitivity tests.
5.1. Partitioning the sample into sub-periods
Results reported in Tables 2 and 3 pool observations over the ten years
1984—1993. In this section, we report relative and incremental information
content tests on annual data grouped into five, non-overlapping, two-year
periods. Because of survivorship bias in the Stern Stewart data, firm-year
observations increase from 1,015 in the 1984—85 period to 1,481 in 1992—93.
In pairwise comparisons of relative information content, adjusted R`s are
largest for EBEI in every two-year period. However, in 1984—85 differences
between EBEI, EVA and RI are not statistically significant at conventional
levels. Using a 5% cutoff, in 1986—87, EBEI does not outperform RI (p"0.072)
but does outperform EVA (p"0.045). In 1988—89 and 1990—91, EBEI outper-
forms each of the other performance measures at the 0.01 level or better. In
1992—93, EBEI does not outperform RI (p"0.083) but does outperform EVA
(p"0.006). Taken together, there is no evidence of EVA (RI or CFO) domina-
ting EBEI. Thus we again cannot support the Stern Stewart claim that EVA has
greater information content than earnings. In contrast, the evidence points to
earnings having higher relative information content in many sub-periods.
We also consider the 606 observations following the September 1993 Fortune
article that touted EVA as “The Real Key to Creating Wealth” (Tully, 1993).
The earnings regression again has the highest R` (11.2%), and the evidence is
suggestive of EBEI dominating EVA (p"0.049) and CFO (p"0.061) but not
RI. Thus market participants apparently did not begin using EVA for equity
valuation immediately following the appearance of the Fortune article.
In incremental information content tests, CFO and Accrual are significant in
every two-year period. Among the remaining EVA components (ATInt, CapChg
and AcctAdj), only 1 of 15 F-statistics is significant at the 5% level — AcctAdj in
the 1984—85 sample period. Results for the period after release of the 1993
Fortune article again show strong support for the incremental information
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 321
content of CFO and Accrual, but little evidence for the incremental significance
of the remaining EVA components.
5.2. Adopters of ‘E»A-like’ performance measures
It is possible that firms adopt EVA at least in part because their past
experience indicates a relatively strong relation between EVA and stock returns.
Further, investors may become more attuned to the measure for firms that
adopt EVA. Thus, it is conceivable that the association between EVA and
returns is stronger for EVA adopters. To examine this possibility, we consider
separately four sub-samples of firms that make some ‘use’ of EVA-like measures.
Firms in the ‘Any’ sample have disclosed that they use EVA (or some similar
concept) sometime during the period studied — even if that use appears to be
minimal. Firms in the ‘Performance’ sample provide more detail about their use
of an EVA-like measure for performance measurement and/or decision making.
Firms in the ‘Comp’ sample state that they use an EVA-like measure in senior
management incentive compensation plans and thus, presumably, also use it for
performance measurement and/or decision making. We include all available
data including years before the plan was implemented. The ‘Comp Year’ sample
restricts observations in the ‘Comp’ sample to only those years in which an
EVA-based compensation plan is in effect. Thus, the ‘Comp Year’ sample is
a subset of the ‘Comp’ sample, which is a subset of the ‘Performance’ sample,
which, in turn, is a subset of the ‘Any’ sample.
Table 4 reports the results of relative information content tests for firms using
an EVA-like performance measure. EBEI exhibits the largest R`s for the ‘Any,’
‘Performance’ and ‘Comp’ groups, but EVA has the largest R` for the ‘Comp
Year’ sample. However, none of the performance measures differ significantly in
relative information content at the 5% level, and only 3 out of 18 comparisons at
the 10% level (EBEI'CFO for the ‘Any’ sub-sample (p"0.073); EBEI'RI
for the ‘Any’ and ‘Performance’ sub-samples (p"0.094 and 0.059, respectively)).
While earnings is not as dominant in these smaller sub-samples of EVA users,
neither do the findings show EVA dominating earnings in its association with
stock returns. The lower significance levels may be attributable in part to the
smaller sample sizes used in these tests.
Table 5 reports tests of incremental information content for users of EVA-like
performance measures. In one-tail t-tests of individual slope coefficients using
a 5% cutoff (t"1.65), 13 of 16 are significant for the CFO and Accrual
components while only 1 of 24 are individually significant for the remaining
EVA components. With the exception of the ‘Comp Year’ group, none of the
two-tail F-tests are significant for components unique to EVA. In the small
‘Comp Year’ sample (n"35), both CapChg and AcctAdj have significant
F-statistics suggesting they make an incremental contribution to explaining
contemporaneous security returns in years where firms have EVA-based
322 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
Table 4
Tests of relative information content (H
"
): Sample partitioned by relative ‘use’ of EVA௡º
Relative information content'
Rank order
of R° Obs. (1) (2) (3) (4)
‘Any’ 626 EBEI ' RI ' EVA ' CFO
Adj. R` 0.0799 0.0523 0.0484 0.0317
p-value° (0.094) (0.867) (0.550)
(0.278) (0.486)
(0.073)
‘Performance’ 445 EBEI ' EVA ' CFO ' RI
Adj. R` 0.0461 0.0386 0.0262 0.0239
p-value (0.765) (0.699) (0.938)
(0.481) (0.491)
(0.059)
‘Comp’ 344 EBEI ' CFO ' EVA ' RI
Adj. R` 0.0306 0.0292 0.0220 0.0181
p-value (0.962) (0.834) (0.855)
(0.735) (0.737)
(0.412)
‘Comp Year’ 35 EVA ' RI ' EBEI ' CFO
Adj. R` 0.3072 0.2644 0.2366 0.1152
p-value (0.352) (0.667) (0.393)
(0.481) (0.330)
(0.211)
ºFirms are categorized in their use of EVA as follows:
E ‘Any’ represents all firms that have mentioned that they use EVA for performance evaluation
and/or explicit incentive compensation — even if that use appears minimal.
E ‘Performance’ represents those firms that have mentioned that they use EVA for performance
measurement but do not disclose any use of EVA in their explicit incentive compensation plans.
E ‘Comp’ respresents those firms that use EVA in their explicit incentive compensation plans and,
presumably therefore, for performance measurement. Given the existence of a plan in any year, all
available firm-years are included.
E ‘Comp Year’ represents a subset of observations from ‘Comp’ only including years where firms
have an EVA-based compensation plan in place.
‘Comp Year’ is a subset of ‘Comp’; ‘Comp’ is a subset of ‘Performance’; and ‘Performance’ is a subset
of ‘Any’.
'Underlying regressions are from Eq. (4): D
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"b
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where
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"market-adjusted returns; X"a given performance measure (EVA, RI, EBEI, CFO); and
MVE"the market value of equity three months after the beginning of the fiscal year. Performance
metrics are lsited in order of R-squares from underlying regression Eq. (4), from highest (on the left)
to lowest (on the right). Statistical tests of differences in explantory power across performance
measures are presented centered in parentheses below the adjusted R-squares. See description of
p-values below.
°Two-tailed p-values in parentheses represent tests of the null hyposthesis of no difference between
pairwise comparisons of adjsuted R-squares (Biddle et al., 1995). First row presents p-values for
comparison between first and second ranked measures, second and third ranked measures and third
and fourth ranked measures. On the next row, comparison are between first and third ranked, and
second and fourth ranked measures. The last row compares first and fourth ranked measures.
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 323
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G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 325
¹` We also evaluated the relative and incremental information content using changes in (rather
than sums of) each performance measure over the five-year period. In relative information content
tests, once again EBEI outperformed EVA. In incremental information content tests, only AcctAdj
for the 1988—93 sub-period was significant at the 5% level while none of the other components
unique to EVA were significant in the predicted direction.
compensation plans in effect. However, caution is warranted in drawing any
inferences from this result due to: the small size of the ‘Comp Year’ sample, the
surprising insignificant F-statistics on CFO and Accrual, and the unexpected
signs on coefficients on CapChg. Again, other than weakly suggestive results for
the ‘Comp Year’ sample, it does not appear users of EVA are adopting the
concept because of its stronger association with stock returns.
5.3. Five-year returns as the dependent variable
In this section we extend the return interval from one year to five years. Stern
Stewart reports its strongest results for EVA on five-year data (Stewart, 1991,
1994). In addition, because five-year data are less sensitive to the choice of
expectations models, these tests help address the possibility that the weaker
performance of EVAis due to a poorer expectations model. Regression (8) below
is used to evaluate relative information content comparisons. It includes non-
lagged and lagged terms similar to the annual return regression (4) and are
analogous to the ‘level and changes’ specification discussed in Section 2.3 and
footnote 9. Independent variables reflect ‘five-year sums’ in that each perfor-
mance measure, X
'
, is summed over the most recent five-year period 1989—93
(for the non-lagged term) and summed over the prior five years, 1984—88 (for the
lagged term).
‘5-year sums’: MktAdjRet
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¹
X
R
/M»E
R`
#b
`
X
R`
/M»E
R`
#e
R
. (8)
Since all ten years of data are used to examine the association between five-year
returns and each performance measure, only one test period is reported in
Table 6. Results again show the earnings regression with the highest R` (31.2%)
followed by CFO (18.9%), EVA (14.5%) and RI (10.9%). The differences in
explanatory power between EBEI and each of the other three performance
measures are highly significant.
In Table 7 we report incremental information content of EVA components
after extending the return interval from one year to five years. CFO and Accrual
are again highly significant but the results on components unique to EVA
(CapChg and AcctAdj) are insignificant.¹`
326 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
¹" We also examined the change in ‘market value added’ (defined by Stern Stewart as firm market
value less invested capital) as a dependent variable with qualitatively similar findings.
Table 6
Tests of relative information content (H
"
): Returns measured over 5-year periodsº
Relative information content
Rank order
of R` Obs. (1) (2) (3) (4)
‘5-year sums’ 509 EBEI ' CFO ' EVA ' RI
Adj. R` 0.3118 0.1888 0.1446 0.1090
p-value' (0.005) (0.264) (0.030)
(0.000) (0.051)
(0.000)
ºUnderlying regression is from Eq. (8):
‘5-year sums’: D
R
"b
"
#b
¹
X
R
/MVE
R`
#b
`
X
R`
/MVE
R`
#e
R
,
where is defined over the five-year intervals, 1989—93 (non-lag) and 1948—88 (lagged) terms,
respectively;
D
R
"market-adjusted returns measured over five years; X"a given performance measure (CFO,
EBEI, RI or EVA); and
MVE"market value of equity three months after the beginning of the fiscal year.
'p-value in parentheses represent two-tail tests of the null hypothesis of no difference between
pairwise comparisons of adjusted R-squares (Biddle et al., 1995). First row present p-values for
comparison between first and second ranked measures, second and third ranked measures and third
and fourth ranked measures. On the next row, comparisons are between first and third ranked, and
second and fourth ranked measures. The last row compares first and fourth ranked measures.
5.4. Two-year (contemporaneous and one-year ahead) returns as
the dependent variable
To consider the possibility that equity market participants take longer to
learn about and impound EVA, we extend the return interval from the one-year
contemporaneous period used above to a two-year period that includes both the
contemporaneous and subsequent year. Consistent with results in Table 2, and
inconsistent with the conjecture that the market subsequently learns about the
importance of EVA, EBEI has significantly higher association with two-year
returns (adjusted R`"4.4%) than any of the other three information variables
(whose R`s range from 2% to 2.3%).
5.5. Market value of the firm as the dependent variable
Another claim made by Stern Stewart is EVA’s higher association with the
market value of the firm.¹" To test this claim, we replicate and extend a study
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 327
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328 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
`" O’Byrne scales EVA by k and capital and NOPAT only by Capital. We cannot replicate results
for free cash flow because O’Byrne (1996) does not provide a precise definition.
`¹ O’Byrne argues that a non-zero intercept makes predicted M» a function of Capital and
therefore an EVA model in disguise. If so, it would follow from our findings that EBEI is a better
proxy for future EVA than is EVA.
authored by Stern Stewart vice-president Stephen O’Byrne (1996). There are
three main differences between O’Byrne’s research and our tests reported above.
First, O’Byrne uses market value of the firm (debt plus equity) as the dependent
variable while we use market-adjusted returns. Second, he draws inferences by
comparing the magnitudes of R`s, while we draw inferences by relying on formal
statistical tests of relative information content. Third, and in our view most
importantly, O’Byrne makes a series of ‘adjustments’ only to the EVA regres-
sions and uses R`s from these adjusted regressions to infer superiority of EVA
over competing information variables.
The initial relations tested in O’Byrne (before ‘adjustments’) are:`"

R
/capital

"
"
#
¹
(EVA
R
/k)/Capital

#e
R
(9)

R
/capital

"
"
#
¹
(NOPAT
R
)/Capital

#e
R
(10)
where
M»t/capital

the market value of debt plus equity deflated by beginning of
period capital.
EVA
R
economic value added for year t, i.e., NOPA¹
R
—k (capital

)
NOPAT
R
net operating profits after tax for year t.
k Stern Stewart’s estimate of the firm’s weighted average cost of
capital.
Capital

Stern Stewart’s definition of assets (net of depreciation) inves-
ted in going-concern operating activities, or equivalently, con-
tributed and retained debt and equity capital, at the beginning
of period t.
e
R
unexplained residual error.
O’Byrne compares R`s from the initial two models and reports 31% for the
EVA model (9) and 33% for the NOPAT model (10). Next, he makes a series of
adjustments to the EVA regressions by: (1) allowing separate coefficients for
positive and negative values of EVA, (2) including the natural log of capital in
an attempt to capture differences in the way the market values firms of different
sizes, and (3) including 57 industry dummy variables in order to capture
potential industry effects. None of these adjustments are made for the NOPAT
regression, and O’Byrne further argues that a pure NOPAT model should be
forced through the origin (p. 120).`¹ After these adjustments, he reports a much
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 329
`` O’Byrne reports adjusted R` of 42% for the EVA model omitting industry intercept dummies.
`` Omitting scaling by the cost of capital (k) from regression Eq. (11) yields R`s of 53% for EBEI,
51% for EVA and 51% for NOPAT. Omitting industry dummies from Eq. (11) (while retaining
scaling by k) yields R`s of 47% for EBEI, 43% for EVA and 41% for NOPAT.
`" These results are not directly comparable with the returns results above since they employ
different functional forms and additional variables due to O’Byrne (1996).
higher R` for the final model containing EVA (56%) than for the final model
containing NOPAT (which, because of the intercept restriction, falls to 17%).``
O’Byrne (1996) (p. 125) concludes:
“EVA, unlike NOPAT or other earnings measures like net income or
earnings per share, is systematically linked to market value. It should provide
a better predictor of market value than other measures of operating perfor-
mance. And, as we have shown, it does provide a better predictor once we
understand and adjust for two critical relationships between EVA and market
value.”
Given the success of earnings in our returns tests discussed above, we add
EBEI to the consideration set and replicate O’Byrne’s final model using 5,843
firm-year observations obtained from Stern Stewart as described earlier. In
Table 8, we treat EVA, NOPAT and EBEI as competing performance measures
and apply O’Byrne’s three adjustments to each variable (as described in regres-
sion Eq. (11) in a note to the table). With this ‘level playing field,’ EVA’s
superiority disappears. With all of O’Byrne’s adjustments (including industry
dummies), the EBEI regression has a significantly higher association with firm
value (adjusted R`"53%) than the EVA regression (50%).`` After making the
same adjustments to the NOPAT regression, the R` of 49% is not significantly
different from the EVA regression. Thus, similar to results reported for our
returns tests above, results in Table 8 provide no evidence of the EVAregression
outperforming earnings in explaining deflated firm values.`"
5.6. Overall assessment of the sensitivity tests
Considering jointly the sensitivity analyses of relative information content
discussed in Sections 5.1, 5.2, 5.3, 5.4 and 5.5, we still find no evidence to support
the Stern Stewart claim that EVA (or RI) outperform EBEI. In only one case
(the ‘Comp Year’ group in Table 4) does EVA and/or RI have a higher R` than
EBEI and this difference is not statistically significant. In contrast, adjusted R` is
highest for EBEI in the remaining comparisons and EBEI significantly out-
performs EVA in several sensitivity tests at the 5% level.
330 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
Table 8
Replication and extension of O’Byrne (1996): Tests of relative information content (H
"
) for EVA௡,
NOPAT and EBEI where the dependent variable is the market value of the firmº
Relative information content
Rank order of R` Obs. (1) (2) (3)
Sample size 5,843 EBEI ' EVA ' NOPAT
Adj. R` 0.5321 0.4965 0.4886
p-value' (0.000) (0.413)
(0.000)
ºUnderlying regression is from O’Byrne (1996):

R
/capital

"b
"
#b
¹
½
R NMQ
/capital

#b
`
½
R LCE
/capital

#b
`
ln(capital

)
#b
H
I
H
#e
R
, (11)
where M»"market value of debt and equity; ½"a given performance measure (EVA, NOPAT,
NI) deflated by the firm’s cost of capital (as estimated by Stern Stewart), where pos and neg refer to
positive and negative values of the performance measure, respectively; capital

"the firms’s
beginning of period contributed capital; and I is a dummy variable representing industry member-
ship.
Performance metrics are listed in order of R-squares fromhighest (on the left) to lowest (on the right).
Statistical tests of differences in explanatory power across performance measures are presented in
parentheses below the adjusted R-squares. See description of p-values below.
'Two-tailed p-values in parentheses represent tests of the null hypothesis of no difference between
pairwise comparisons of adjusted R-squares (Biddle et al., 1995). First row present p-values for
comparison between first and second ranked measures and second and third ranked measures. On
the next row, comparisons are between first and third ranked. Tests based on Vuong (1989) are
qualitatively identical.
In terms of incremental information content, the analyses in Section 5 provide
only limited evidence that components unique to EVA (i.e., CapChg and
AcctAdj) add to the information set that includes earnings (i.e., CFO and
Accruals), e.g., only two of the F-statistics and none of the t-statistics on CapChg
and AcctAdj are significant at the 5% level. Thus, from the sensitivity tests in
Section 5, we find no evidence that EVA dominates earnings in its association
with stock returns or firm values.
6. Summary and potential limitations
Motivated by increased use in practice and increased interest in the media and
among academics, we examine the value-relevance of EVA and residual income
compared to currently-mandated performance measures — earnings and cash
flow from operations. There is little evidence to support the Stern Stewart claim
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 331
that EVA is superior to earnings in its association with stock returns or firm
values. In no case does EVA significantly outperform EBEI in tests of relative
information content. On the contrary, in most cases the evidence suggests that
earnings outperforms EVA. Further, while the charge for capital and Stern
Stewart’s adjustments for accounting ‘distortions’ show some marginal evidence
of being incrementally important, this difference does not appear to be economi-
cally significant. Possible reasons why we do not detect stronger value-relevance
for EVA include:
E Our research design uses current realizations, not future flows, of each
performance measure. Equity valuation is ultimately the discounted present
value of future equity cash flows (or dividends or RI or EVA). Even if EVA is
a good proxy for economic profits, realized EVA may not outperform the
current realizations of other performance measures such as earnings in
proxying for future equity cash flows. This is similar to the rationale used
to explain why EBEI generally outperforms CFO in relative information
content.
E Stern Stewart’s estimates of the charge for capital and accounting adjust-
ments may contain measurement error relative to what the market is
using to value firms. Further, we use Stern Stewart’s publicly available
database which does not include many custom adjustments they use for their
clients.
E There exists little or no ‘surprise value’ in components unique to EVA
including the capital charge and Stern Stewart’s accounting adjustments. For
example, if the cost of capital and the amount of capital are slow to change (or
the changes are predictable months or years in advance), the market should
long ago have impounded these data. However, over five-year return inter-
vals, the opportunity for surprise should be larger, and results reported in
Section 5.3 do not lend support for the superiority of EVA over this longer
return interval.
E Data needed to compute EVA are not easily estimated and the market does
not have these data during our test period. Recall that we assume that the
market has access to sufficient data within three months of a firm’s fiscal year
end such that EVA (and its components) can be reliably estimated by that
time. This potential issue is mitigated in tests that use alternative dependent
variables (i.e., five-year return intervals in Section 5.3, two-year return inter-
vals that include both contemporaneous and one-year ahead returns in
Section 5.4, and firm values in Section 5.5). Again the evidence does not
support the superiority of EVA.
E In attempting to approximate economic profits, adjustments made by Stern
Stewart may remove accruals that market participants use to infer firms’
future prospects. These could be discretionary accruals that managers use to
‘signal’ future prospects or nondiscretionary accruals that are by-products of
332 G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336
`` Collins and DeAngelo (1990), Subramanyam (1996), and Hunt et al. (1997) report evidence
consistent with discretionary accruals increasing the informativeness of earnings. Wu (1997) presents
an agency model in which firms will optimally choose accounting adjustments for internal perfor-
mance metrics that serve to reduce their correlation with stock returns.
`" Wallace (1996, 1998) reports that some adopters of EVA feel they must still base their external
performance on earnings because this is the measure on which financial analysts continue to
focus.
the accounting process.`` Thus, in constructing EVA, it is possible that
Stern Stewart obtains a measure that is closer in level to economic profits
(than say EBEI), but at the same time reduces its association with stock
returns.
E In violation of our maintained hypothesis of semi-strong market efficiency,
the market may have failed to recognize the reporting benefits of EVA
through the period we study, consistent with the notion of ‘earnings
myopia’.`" As more data become available, future studies will be able to
assess whether market participants have come to appreciate EVA. It also is
possible to imagine a new equilibrium in which firms would disclose EVA
rather than earnings. However, this would subject EVA to many of the same
legal and regulatory influences, and as a consequence, the resulting metric
might closely resemble earnings (or what earnings might become). For this
reason, and despite its alleged advantages for internal decision making, we do
not anticipate that EVA will displace earnings for financial reporting pur-
poses.
Until further research can be conducted, our conclusion is that, although for
some firms EVA may be an effective tool for internal decision making, perfor-
mance measurement and incentive compensation, it does not dominate earnings
in its association with stock market returns for the sample firms and period
studied. To the contrary, and in contrast to claims by Stern Stewart, our
evidence suggests that earnings generally dominates EVA in value-relevance to
market participants.
An avenue for future research suggested by the findings of this study is to
examine more closely which components of EVA and earnings contribute to, or
subtract from, information content. For example, ex ante, capitalizing R&D and
marketing costs should only add to EVA’s information content given both are
generally expensed in the determination of earnings. In contrast, by estimating
taxes paid in cash (rather than tax expense), EVA may lose information content
by removing value-relevant deferred tax accruals. Research at this level of detail
requires data that are currently unavailable from Stern Stewart on individual
adjustments used in the calculation of EVA.
G.C. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 333
Acknowledgements
Helpful comments were provided by Bill Alberts, Mary Barth, William
Beaver, Dave Burgstahler, George Foster, Bob Holthausen (the referee), Alister
Hunt, Jane Kennedy, Dawn Matsumoto, Brian McCulloch, Jim Patell, Mark
Peecher, Terry Shevlin, D. Shores, Naomi Soderstrom, Jerry Zimmerman, and
workshop participants at the Chinese University of Hong Kong, City University
of Hong Kong, European Accounting Association Meetings, Hong Kong Uni-
versity of Science & Technology, National Chengchi University, Northwestern
University, New York University, Stanford University, and the University of
Washington. Funding was provided by the Accounting Development Fund at
the University of Washington, the Herbert O. Whitten Professorship and
a Hong Kong Research Grants Council Direct Allocation Grant.
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Marshall, 1890). In the twentieth century, this concept has been operationalized under various labels including residual income. Residual income has been recommended as an internal measure of business-unit performance (Solomons, 1965) and as an external performance measure for financial reporting (Anthony, 1973, 1982a,b). General Motors applied this concept in the 1920s and General Electric coined the term ‘residual income’ 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 (EVA ), be used instead of earnings or cash from operations as a measure of both internal and external performance. They argue: “Abandon earnings per share” (Stewart, 1991) (p. 2). “Earnings, earnings per share, and earnings growth are misleading measures of corporate performance” (Stewart, 1991), (p. 66). “The best practical periodic performance measure is economic value added (EVA)” (Stewart, 1991 (p. 66). “Forget EPS, ROE and ROI. EVA is what drives stock prices” (Stern Stewart advertisement in Harvard Business Review, November—December, 1995, p. 20). Stewart (1994) cites in-house research indicating that “EVA stands well out from the crowd as the single best measure of wealth creation on a contemporaneous basis” and “EVA is almost 50% better than its closest accounting-based competitor in explaining changes in shareholder wealth” (p. 75). This study provides independent empirical evidence on the information content of EVA, residual income, and two mandated performance measures, earnings and cash flow from operations. Our inquiry is motivated by: the claims cited above, interest in EVA in the business press, increasing use of EVA by firms, 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 ‘allnews’ library). Fortune has touted EVA as “The Real Key to Creating Wealth” (30 September 1993), “A New Way to Find Bargains” (9 December 1996), and has begun augmenting its well-known ‘500’ ranking with an annual 
Residual income is generally defined as after-tax operating profits less a charge for invested capital. Operating profits are profits before deducting the after-tax cost of interest expense. The firm’s weighted average cost of debt and equity capital is deducted in the capital charge. Other labels include: abnormal earnings (Feltham and Ohlson, 1995); excess earnings (Canning, 1929, Preinreich, 1936, 1937, 1938); excess income (Kay, 1976; Peasnell, 1981, 1982); excess realizable profit (Edwards and Bell, 1961); and super-profits (Edey, 1957).  Stern Stewart & Company is a New York-based consulting firm that markets the ‘EVA Financial Management System’ for internal and external performance measurement and incentive compensation. Performance measures marketed by competing firms include cash-flow return on investment (CFROI) by Boston Consulting Group’s HOLT Value Associates, discounted cash-flow analysis (DCA) by Alcar, discounted economic profits (EP) by Marakon Associates, and economic value management (EVM) by KPMG Peat Marwick.

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‘Performance 1000’ based on data from Stern Stewart (Tully, 1993, 1994; Fisher, 1995; Lieber, 1996; Teitelbaum, 1997). Companies that have adopted EVA for performance measurement and/or incentive compensation include AT&T, Coca Cola, Eli Lilly, Georgia Pacific, Polaroid, Quaker Oats, Sprint, Teledyne and Tenneco. The ‘EVA Financial Management System’ is alleged to encourage managers to act more like owners by helping managers make improved operating, financing and investment decisions. Evidence provided in Wallace (1997) suggests that managers compensated on the basis of EVA (instead of earnings) take actions consistent with EVA-based incentives. Recently, academics have shown interest in models of equity valuation that express firm value in terms of book value and the expected stream of residual income or ‘abnormal earnings’ (Ohlson, 1995; Feltham and Ohlson, 1995). Our study provides empirical evidence on whether current period realizations of residual income (RI) and EVA are more closely associated with stock returns than are traditional accounting measures such as earnings and cash from operations (CFO). Finally, data on the information content of EVA and RI provide potentially useful input to the normative policy debate on what performance measure(s) should be reported in financial statements. Financial reporting has been criticized for low-quality and lack of relevance in today’s information-rich environment. The AICPA Special Committee on Financial Reporting (1994), the Jenkins Committee, makes suggestions for improving financial reporting that are consistent with firms using EVA for internal decision making and external reporting. A prediction from an April 1995 AICPA workshop on the future of financial management is that EVA will replace EPS in ¹he ¼all Street Journal’s regular stock and earnings reports (Zarowin, 1995) (p. 48). Widespread interest in revisiting the quality of financial reporting suggests that alternatives to currently mandated performance measures should be evaluated for 

CFO Basil Anderson of Scott Paper states: ‘‘We used to have different financial measures for different purposes — discounted cash flow for capital decisions, another measure for rewarding performance and the like. 2 Now EVA is one measure that integrates all that. 2 it offers an excellent link to the creation of shareholder value’’ (Walbert, 1994) pp. 111—112. Jim Meenan, CFO of AT&T’s communications services group expresses a similar view: ‘‘Every decision is now based on EVA. The motivation of our business units is no longer just to make a profit. The drive is to earn the cost of capital. 2 when you drive your business units toward EVA, you’re really driving the correlation with market value’’ (Walbert, 1994) (p. 112). Eugene Vesell, managing director of Oppenheimer Capital states: ‘‘The first thing we look at when we pick companies is, are they motivated by EVA? We prefer it to measures like EPS or return on equity.’’ (Tully, 1994) (p. 143).  We emphasize that our results are only an input to the policy making process. Each of the measures we consider may have value in other decision contexts, e.g., cash from operations may provide valuable information to lenders and suppliers about liquidity. Questions regarding cost and best source(s) of data are beyond the scope of this research.

This study provides evidence that we hope will be useful to policy makers who may be interested in EVA or RI as replacements (or complements) to earnings and CFO as key measures of firm performance. Biddle et al. tests of question 1 indicate that earnings (R"12. cash from operations. capital charge. and describes statistical tests for relative and incremental information content.C. Second.174 firm-years representing both adopters and non-adopters of EVA over the period 1984—1993. earnings and operating cash flow. we examine whether EVA and/or RI complement currently mandated performance measures.. tests across alternative specifications indicate that. The remainder of the paper is organized as follows. while each component is significantly associated with market-adjusted returns. neither EVA nor RI appears to dominate earnings in its association with stock market returns. (In Section 5. presents hypotheses. Section 2 provides a description of EVA and its components.8%) is significantly more highly associated with market-adjusted annual returns than are RI (R"7. The first (of two) empirical questions we address is Q1: Do EVA and/or RI dominate currently mandated performance measures.5 we examine separately another Stern Stewart claim that EVA outperforms earnings in explaining firm values.5%) and that all three of these measures dominate CFO (R"2.) Using a sample of 6.8%). we decompose EVA into components (e. RI. the EVA components do not appear to be economically significant. and accounting ‘adjustments’) and evaluate the contribution of each component toward explaining contemporaneous stock returns. earnings and CFO: Q2: Do components unique to EVA and/or RI help explain contemporaneous stock returns beyond that explained by CFO and earnings? This is equivalent to asking: Does the market appear to value a given EVA component beyond the information contained in the other components? To address this incremental information content question.g.3%) or EVA (R"6. CFO or earnings) have a greater association with contemporaneous stock returns and provides a direct test of one of Stern Stewart’s claims about the superiority of EVA. This finding is supported across a number of alternative specifications.304 G. Section 3 . For the full sample. operating accruals. Considering the relative and incremental information content results together. while cash flow and accrual components are consistently significant. / Journal of Accounting and Economics 24 (1997) 301–336 value-relevance. in explaining contemporaneous annual stock returns? This relative information content question examines which variables (EVA. components unique to EVA (capital charge and accounting adjustments) are typically not significant. Further.

and descriptive statistics. where ATInt"the after-tax equivalent of book interest expense. we define net operating profits after tax (NOPAT) as EBEI plus the after-tax cost of interest expense NOPAT"EBEI#ATInt.G. earnings. and non-current portion of deferred taxes. We begin by partitioning earnings into operating cash flows and accruals: EBEI"CFO#Accrual. .1.. Biddle et al. Next. / Journal of Accounting and Economics 24 (1997) 301–336 305 reports sample selection criteria. current liabilities (other than notes payable and current portion of long-term debt). where k " Stern Stewart’s estimate of the firm’s weighted average cost of capital. e. NOPAT separates operating activities from financing activities by adding back the after-tax effect of debt financing charges (interest expense) included in EBEI. 2. Section 4 provides empirical results on the relative and incremental information content of EVA and its components. non-cash current assets. earnings before extraordinary items (EBEI). We close with a summary and a discussion of potential factors contributing to the failure of EVA and/or RI to dominate earnings.g. Linkages between operating cash flow. Residual income differs from EBEI in that it measures operating performance (NOPAT) net of a charge for the cost of all debt and equity capital employed: RI"NOPAT!(k*Capital). Components of EVA. amortization. variable definitions. where CFO " net cash provided by operating activities. Accrual " total accruals related to operating (as opposed to investing or financing) activities. Section 5 reports various extensions and sensitivity analyses. depreciation.C. residual income and E»A This section describes linkages between operating cash flows (CFO). hypotheses and statistical tests 2. residual income (RI) and economic value added (EVA).

warranties. adding other operating income. or equivalently. asset lives and amortization patterns.  Other adjustments to Capital include: capitalization and amortization of certain marketing costs. adding the present value of non-capitalized long term leases. e. etc. Stern Stewart do not disclose complete details about their accounting adjustments. AcctAdj reflect the cumulative effect on Capital of the capitalization and amortization of current and past R&D expenditures. This requires adjustments to both NOPAT (via AcctAdj )  and to Capital (via AcctAdj ). NOPAT is adjusted by adding back the period’s R&D expense and deducting amortization of the R&D asset.g. 112—117).306 G. net of taxes (Stewart. and adding (subtracting) cumulative unusual losses (gains).  where AcctAdj " Stern Stewart adjustments to accounting measures of operating  profits. thus. contributed and retained debt and equity capital. adding the LIFO reserve.. 1991) (pp. Biddle et al. At any point in time. adding the change in the LIFO reserve. 28—30) argues that research and development costs should be capitalized (if material) and amortized. EVA is Stern Stewart’s proprietary version of RI. Negative RI is consistent with decreasing shareholder wealth. adding cumulative goodwill amortization. 1991) (pp. is consistent with the firm creating wealth for the residual claimants.C. subtracting marketable securities and construction in progress (because neither contributes to current operating activities). Stern Stewart attempts to improve on RI by adjusting NOPAT and Capital for what they view to be ‘distortions’ in the accounting model of performance measurement (Stewart. 1991) (Chapter 2): EVA"NOPAT#AcctAdj !k*[Capital#AcctAdj ]. AcctAdj " Stern Stewart adjustments to accounting measures of capital. the shareholders.  Other adjustments to NOPAT include: adding the change in bad debt allowances. AcctAdj and AcctAdj are not examined individually in subsequent  empirical tests because Stern Stewart does not disclose them separately. Stewart (1991) (pp. / Journal of Accounting and Economics 24 (1997) 301–336 Capital " Stern Stewart’s definition of assets (net of depreciation) invested in going-concern operating activities. and subtracting an estimate of taxes owed for the period (Stewart. 742—743). inventory obsolescence. at the beginning of the period. Capital is higher by the amount of the net capitalized R&D asset. In any given year. adding goodwill amortization. the net effect is an increase (decrease) in NOPAT if R&D expense is greater (less) than R&D amortization. adding unrecorded goodwill. adding allowances for bad debts. adding net capitalized intangibles (including R&D). .. Positive RI reflects profits in excess of that required by debt and equity capital suppliers and. As an example of a common accounting adjustment.

i. forward-looking and can form estimates of performance measures.e. 1995.. Components of economic value added (EVA). we draw a distinction between relative and incremental information content. EVA can be decomposed into its component parts: EVA"CFO#Accrual#ATInt!CapChg#AcctAdj. incremental information content comparisons assess whether one measure provides value-relevant data beyond that provided by another measure and apply when assessing the information content of a supplemental disclosure or the information of a component measure (e. RI and EVA. Biddle et al. 1. In contrast.2... 1 summarizes these relations by showing how EVA components combine into other performance measures. We use this decomposition to examine the incremental information content of EVA components. of CFO. where CapChg"k*Capital AcctAdj"AcctAdj !(k*AcctAdj ). 1987).  Fig. Relying on the above definitions. 2. Relative information content comparisons are appropriate when one desires a ranking of performance measures by information content or when making mutually exclusive choices among performance measures.. we use stock market returns to compare the information content. EBEI and RI. when only one measure can be chosen. i. Following Biddle et al.G.C. or value-relevance..g. .e. / Journal of Accounting and Economics 24 (1997) 301–336 307 Fig. EBEI. Bowen et al. CFO. Hypotheses By assuming that equity markets are (semi-strong) efficient.

.308 G. / Journal of Accounting and Economics 24 (1997) 301–336 Despite claims by Stern Stewart and others that EVA and RI are more value-relevant to market participants than EBEI and CFO. 1 by testing the null hypotheses that individual components of EVA do not provide incremental information content beyond other components that also comprise CFO and EBEI: H : Component X does not provide information content beyond that pro'  vided by the remaining components X —X   where X —X are components of EVA (i.C. b . We examine the incremental value relevance of EVA components summarized in Fig. Statistical tests A standard approach for assessing information content is to examine the statistical significance of the slope coefficient. CFO. RI and EVA have equal relative information content: H : The information content of measure X is equal to that of X 0   where X and X represent pairwise combinations from the set of performance   measures: CFO. we use an approach from Biddle and  The MVE deflator is measured 3 months after the prior year end to be consistent with the start of the returns period measured by the dependent variable. Accrual.. in the following ordinary least-squares regression (that omits firm subscripts): D "b #b FE /MVE #e R   6R R\ R (1) where. RI and EVA. scaled by the beginning-of-period market value of the firm’s equity. Biddle et al. RI or EVA). FE /MVE is the unexpected realization (or forecast 6R R\ error) for a given accounting measure. CFO. CapChg and   AcctAdj). EBEI. 2. ATInt. MVE . . EBEI. X (e. EBEI. D is the dependent variable.e.g.3. Because little is known about suitable proxies for market expectations for performance measures other than earnings. Rejection of H is viewed as evidence of 0 a significant difference in relative information content. a measure of (abnormal or unexpected) R returns for time period t. Rejection of H is viewed as evidence of incremental information ' content. we take a neutral position and conduct two-tail tests of the null hypotheses that CFO. and e is R\ R a random disturbance term.

Results based on these specifications are qualitatively similar to those reported and are available from the authors. It is then assumed that market expectaR R R tions are formed according to a discrete linear stochastic process (in autoregressive form): E(X )" # X # X # X #2 R  R\  R\  R\ (2) where the is a constant and ’s are autoregressive parameters. in the presence of possible structural change across time. / Journal of Accounting and Economics 24 (1997) 301–336 309 Seow (1991) and Biddle et al. we limit Eq. Substituting Eq. ARIMA. It also is in a more convenient form that allows the slope or ‘response’ coefficient (b ) to be   We also consider a specification that allows each information variable to be predicted by lagged observations of all of the information variables. (3). and E(b)"!b G G\ G      i'1. This is one way of addressing the potential concern that (say) EVA is less well predicted by past observations of EVA than (say) EBEI is predicted by past values of EBEI. (3) relates abnormal returns and (scaled) lagged measures of accounting for performance. Eq.  R\ R\ R (3) Eq. EBEI.. (2) into Eq.C. say EVA.G. (3) is flexible in terms of allowing any number of lagged observations to be included as explanatory variables. 1995 that estimates market expectations ‘jointly’ with slope coefficients. In Eq. and combined ‘levels and changes’ specifications. but it is motivated differently. (1) yields: D "b #b (X !( # X # X # X #2))/MVE R   R  R\  R\  R\ R\ #e "b #b X /MVE #b X /MVE #b X /MVE R   R R\  R\ R\  R\ R\ #b X /MVE #2#e . R   R R\  R\ R\ R (4) This ‘one-lag’ version is equivalent to the ‘levels and changes’ specification proposed by Easton and Harris (1991). Biddle et al. (3) encompasses a range of alternative specifications for market expectations. Thus each information variable. is predicted by lagged values of each of the other variables — CFO. RI and EVA. including random-walk. the proxy for market expectations is estimated jointly with the slope coefficient (b) using the same data and optimization criterion (minimum G mean squared errors). . Although Eq. This is accomplished by first expressing the forecast error as the difference between the realized value of a performance measure and the market’s expectation: FE "X !E(X ). where E(b )"b !b . (3) to one lag: D "b #b X /MVE #b X /MVE #e . E(b )"b . constant stock price multiple.

generalizes to any number of predictor variables. Dechow. this method for assessing relative information content compares favorably with alternative tests provided in Davidson and MacKinnon (1981) and Vuong (1989).3. As a result. we employ a statistical test from Biddle et al. Using this test. (4c) corresponds to Eq. (4) where b "a #a and b "!a .. Both are valid only asymptotically and may have poor finite sample properties. as specified in Eq. The J-test also can yield ambiguous results.g. The coefficient(s) on the non-lag   term(s) can be interpreted directly as ‘response’ coefficient(s). it is well suited to evaluate the significance of relative information content comparisons in accounting contexts.  The relation between the two specifications can be illustrated by starting with the levels-changes specification (in Eq. Tests for relative information content To assess relative information content. As confirming evidence. which is problematic in applications assessing relative information content. As discussed in Biddle et al. (4c)): D "a #a X /MVE #a (X !X )/MVE #e (4a) R   R R\  R R\ R\ R "a #a X /MVE #a X /MVE !a X /MVE #e (4b)   R R\  R R\  R\ R\ R "a #(a #a )X /MVE !a X /MVE #e . By using a lack-of-fit measure defined as the average of the sum of squared residuals and the sum of squared prediction errors. a nonlinear null hypothesis is obtained that involves quadratic forms of regression coefficients. it is finite sample exact.310 G. EBEI. Lys and Sabino (1996) provide evidence that Vuong’s test outperforms the J-test. we make six pairwise comparisons of regressions among the accounting performance measures CFO. Davidson and MacKinnon’s non-nested ‘J-test’ and Vuong’s likelihood ratio test are ‘pairwise tests for model selection’ designed to assess which of two competing models is closer (in terms of Kullback-Liebler distance) to the ‘truth’. (4a)) and deriving the one-lag specification (in Eq. (4c) the response coefficient is (a #a ). (1995) that allows a test of the null hypothesis of no difference in the ability of two competing sets of independent variables to explain variation in the dependent variable. / Journal of Accounting and Economics 24 (1997) 301–336 observed directly (rather than being derived from separate coefficients on levels and changes). 2. and can be used in conjunction with White’s (1980) correction for heteroskedastic errors. in Eq. (4). b (b ) is predicted to be positive (negative). Since a and a are both        expected to be positive. (4c)    R R\  R\ R\ R Eq. 1985) of estimated coefficients and their heteroskedasticityadjusted variance—covariance matrix.    The Biddle—Seow—Siegel test derives from Hotelling (1940). e. RI and EVA. (1995).1. It is tested using a Wald test (Kennedy. we replicated our relative information content tests using Vuong’s test with qualitatively similar results as discussed briefly in Section 4 below. Biddle and Siegel (1996) provide evidence that the Biddle—Seow—Siegel test performs as well as or better than Vuong’s test in calibration and power. Under usual regularity conditions (uncorrelated homoskedastic errors). . The test is constructed as a comparison of Rs. Biddle et al.C.

174 firm-year observations for 773 firms.1.G. We also delete 79 extreme outlier observations defined as more than 8 standard deviations from the median. 7   where b . for the one-lag specification in Eq. (1987)). (5)  R\ R\ R To control for the potential effects of heteroskedastic errors. Bowen et al. 3. 6   H : b "b "0. Specifically. or 0. The resulting sample has 6. Sample selection Data used in this study were purchased directly from Stern Stewart & Co.57% of the 6. . For their corporate clients.. data greater (less) than 4 standard deviations from the median of the firm-year observations are assigned a value equal to the median plus (minus) 4 standard deviations. The total number of observations reset for any variable range from 51 to 97.83% to 1. Stern Stewart make ‘a handful’ of standard adjustments. Next. incremental information content is assessed using t-tests on individual coefficients and F-tests of the joint null hypotheses: H : b "b "0.g. variable definitions and descriptive statistics 3. and cost of capital for firms with fiscal years ending June 1983 to May 1994 (see variable definitions below). Biddle et al.174 sample firm years.524 firm-year observations) is reduced by 219 firms (2. (4) generalized to two accounting performance measures X and ½. b and b are from Eq. b .271 observations) due to either missing Compustat or CRSP (Center for Research in Securities Prices) data or to provide a lagged observation for each variable.  In other words. The initial sample of 1000 firms (8. Tests for incremental information content Following standard methodology (e. capital. incremental information content is assessed by examining the statistical significance of regression slope coefficients.  For their publicly available database used in this study. both the dependent and independent variables are winsorized to $4 standard deviations from the median.3.C. White’s (1980) correction is employed in both the relative and incremental information content tests. These data include up to eleven annual observations for economic value added (EVA). Stern Stewart make additional custom adjustments (not available to the public). (5) below:     D "b #b X /MVE #b X /MVE #b ½ /MVE R   R R\  R\ R\  R R\ #b ½ /MVE #e . Sample selection.2. / Journal of Accounting and Economics 24 (1997) 301–336 311 2.

Bowen et al. A 12-month nonoverlapping period ending three months following the firm’s fiscal year-end is chosen to allow time for information contained in the firm’s annual report to be impounded in stock market prices. is used if the firm used the cash definition of funds for the statement of changes in financial position. and then adding firms from prior Business ¼eek 1000 listings to bring the sample back to 1.000 firms. RI and EVA. CFO.g. EBEI. 3. For years prior to 1988. 1995. If the firm used the working capital definition of funds in any year prior to 1988. funds from operations — total.2.000 largest firms in market capitalization.3.. 1987) as funds from operations (D110) plus the change in current liabilities (D5) less the change in debt in current liabilities (D34) less the change in current assets (D4) plus the change in cash and cash equivalents (D1). Stern Stewart modifies this list by first removing utilities and financial institutions. is commonly used in information content studies to measure unexpected returns (e.. MktAdjRet Market adjusted return computed from CRSP data as a firm’s 12-month compounded stock return less the 12-month compounded value-weighted market-wide return. For years after 1987 Compustat data item D308. (1986. market adjusted returns. . Dependent variable Our dependent variable. Independent variables and descriptive data — relative information content tests The four measures of accounting performance in the relative information content tests. cash flow from operations is estimated similar to Bowen et al. Biddle et al.C. 1989). Rs in two-year sub-periods from 1988 onward are slightly higher than for the two. are defined below: CFO Cash flow from operations obtained from the statement of cash flows or the statement of changes in financial position. depending upon the year of the observation. two-year sub-periods before 1988. Biddle et al.. The listing is published annually.  Consistent with the possibility that pre-1988 measures of CFO are noisy. is used. Stern Stewart introduced its first 1000 ranking for the calendar year ended 1988. operating activities — net cash flow. / Journal of Accounting and Economics 24 (1997) 301–336 These data are compiled by Stern Stewart & Company from Business ¼eek’s listing of the 1. data item D110. 3.312 G.

Biddle et al. Economic value added obtained from the Stern Stewart 1000 database.C. 2. After tax interest expense computed as 1 minus the firm’s tax rate multiplied by interest expense (D15). ATInt is non-negative. Despite a survivorship bias in the data.1 and summarized in Fig. Accruals can be positive or negative but are more likely to be negative (reflecting non-cash expenses such as depreciation and amortization). 1: CFO (defined above). Undeflated median values of each performance measure are plotted across time in Fig. Otherwise the maximum statutory corporate tax rate is used for the given year.4 below for definitions of ATInt and CapChg. Near zero EVA and RI is consistent with a competitive economy where even the typical large firm has difficulty earning more than its cost of capital. EBEI has the highest correlation with market adjusted returns.G. Descriptive data on these deflated. net income before extraordinary items. The firm’s tax rate is assumed to be zero if net operating losses are present. ATInt . operating accruals. EVA and RI. Correlations between the independent variables are all positive and significant except that EVA and RI are negatively correlated with CFO. EBEI has the lowest standard deviation among the four performance measures consistent with the smoothing effects of accruals. we deflate all independent variables by the market value of equity three months after the beginning of the fiscal year (MVE ). In order to reduce heteroscedasticity in the data. median RI is negative in every year and median EVA is negative in 7 out of 10 years. 3. Residual income equals earnings plus after-tax interest expense less a charge on all capital (RI"EBEI#ATInt!CapChg). See Section 3. Low values of EVA and RI are also consistent with a potential upward bias in Stern Stewart’s cost of capital estimates. CFO has the largest firm-year mean and median followed by EBEI. / Journal of Accounting and Economics 24 (1997) 301–336 313 EBEI RI EVA Earnings defined as Compustat data item D18.4. Correlations among these measures are provided in Panel A of Table 1. winsorized variables R\ pooled across time are provided in Panel A of Table 1. capital charge and accounting adjustments: Accrual Operating accruals defined as earnings less cash flow from operations (Accruals"EBEI!CFO). after-tax interest expense. Independent variables and descriptive data — incremental information content tests The independent variables in the incremental information content tests are the five components of EVA described in Section 2.

00 0.059 0.004 0.057 !0.054 0.C.592 0.00 0.751 0. Dev. Biddle et al.049 !0.086 !0.362 0.362 0.0319 are significant at (0.363 0.210 1.125 0.133 EBEI R Independent variables EVA R RI R CFO R 1. Correlations MktAdjRet  EBEI R EVA R RI R CFO R 1.138 1.900 !0.057 1.142 0.580 0.055 CFO R Independent variables Accrual R ATInt R CapChg R AccAdj R 1.127 0.00 The sample has 6. Correlations MktAdjRet  CFO R Accrual R ATInt R CapChg R AccAdj R 1. Pearson correlation coefficients '0.149 0.00 0.652 0.118 0.133 !0.314 G.01 '0.026 !0.118 0.0407 are significant at (0.007 !0.247 0.469 0.039 1.018 !0.017 0.055 0.501 !0.111 0.001 .129 !0.153 0. / Journal of Accounting and Economics 24 (1997) 301–336 Table 1 Descriptive statistics for pooled data Panel A: Descriptive statistics on the dependent and independent variable in relative information content tests Dependent variable MktAdjRet  Descriptive statistics Mean Median Std.174 firm-year observations. All variables are winsorized $4 standard deviations from the median.007 0.0204 are significant at (0.900 !0.00 0.782 0.137 0.307 0.10 '0.155 0.016 0.122 1.00 0.142 0.011 0.00 Panel B: Descriptive statistics on the dependent and independent variable in incremental information content tests Dependent variable MktAdjRet  Descriptive statistics Mean Median Std.011 1.021 !0. All independent variables are deflated by the market value of equity three months after the beginning of the fiscal year.138 0. Dev.00 !0.082 !0.065 0.059 0.00 !0.056 !0.011 0.00 0.034 0.007 0.134 !0.

741—745. Stern Stewart estimate the cost of capital by weighting the cost of equity (applying the capital asset pricing model) and the after-tax cost of debt. / Journal of Accounting and Economics 24 (1997) 301–336 315 Fig. CapChg is positive since both the cost of capital and capital are positive. Capital is a proxy for all cash invested in the business since a company’s inception. 1984—93. Biddle et al.  Our definition of RI incorporates Stern Stewart adjustments to capital. CapChg AcctAdj Capital charge defined as the firm’s weighted average cost of debt and equity capital times its beginning of year capital. 2. Data were not available from Stern Stewart to calculate capital before accounting adjustments. Both of these items are obtained from Stern Stewart. See Stewart (1991).G.  According to Stewart (1994). especially pp. . Accounting adjustments reflect Stern Stewart’s net annual adjustments to earnings and capital. and are defined as economic value added less residual income (AcctAdj"EVA!RI). Median values of performance measures. AcctAdj can be positive or negative.C.

For example.00001) for each performance measure based on   the full sample of 6. coefficient b (b ) is positive (negative) and significant (at (0. we predict a positive (negative) slope coefficient on contemporaneous (lagged) observations of each performance measure. ATInt and CapChg are positive and significant. winsorized EVA components are provided in panel B of Table 1. RI significantly outperforms EVA (although the gap here is smaller). the Vuong test provides greater statistical significance. The negative correlation between CFO and Accrual is again consistent with the accrual process smoothing earnings relative to the underlying operating cash flows. / Journal of Accounting and Economics 24 (1997) 301–336 Descriptive data on these deflated. CFO has by far the largest correlation with market-adjusted returns.  On average. with EBEI having a significantly larger adjusted R (9%) than each of the other three performance measures. 4. consistent with its asymptotic nature and tendency to reject the null observed in simulation tests (Biddle and Siegel. EBEI.316 G. The negative coefficient on the lagged term follows from the prediction that changes in the performance measures also are positively associated with stock returns (see Section 2. Both mean and median Accrual and AcctAdj are negative. In general. consistent with some smoothing of the underlying operating cash flows.174 firm-years. identical inferences are obtained at conventional significance levels for all pairwise comparisons. (4) and each of the six pairwise differences in R are significant at conventional levels.3. and all three outperform CFO. . Empirical results 4. Relative information content tests Relative information content is assessed by comparing adjusted Rs from four separate regressions. In results available from the authors.2%) than does the EVA regression (5. p-values from two-tailed statistical tests of relative information content are shown centered in parentheses for each of the six possible pairwise comparisons. RI and EVA. for the relative comparisons in Panel A of Table 2 and Table 4.  Nearly identical inferences are obtained using the Vuong (1989) test. The RI regression has a significantly larger adjusted R (6.1%). Biddle et al. especially footnote 9). and both have a significantly larger adjusted Rs than CFO (2. consistent with firms with higher operating cash flows also having higher debt and equity costs. in terms of relative information content. 1996). Adjusted Rs from these regressions are provided in Table 2.4%). earnings significantly outperforms RI. one for each performance measure. Results in Panel A of Table 2 are based on Eq. Correlations between CFO. These results suggest that.C. The highest R is shown on the left (which in both panels is from the EBEI regression) and the lowest is shown on the far right (which in both panels is from the CFO regression).1. The correlation between CFO and AcctAdj is insignificant. CFO.

RI or EVA). RI 0. On the the next row. Statistical tests of differences in explanatory power across performance measures are presented centered in parantheses below the adjusted R-squares.0624 ' (0. (4) modified to allow different coefficients on positive versus negative values of the independent variables: D "b #b X /MVE #b X /MVE #b X /MVE R   R  R\  R  R\  R\  R\ #b X /MVE #e (6)  R\  R\ R where D "market-adjusted returns.000) EVA 0. Hayn (1995).0904 ' (0. residual income.000) Panel B: Coefficient of positive and negative values of each performance measure allowed to differ All firms Adj.0507 ' (0. Two-tailed p-values in parentheses represent tests of the null hypothesis of no difference between pairwise comparisons of adjusted R-squares (Biddle et al. Biddle et al. Underlying regressions are from Eq. EBEI.000) CFO 0. R and MVE"market value of equity three months after the beginning of the fiscal year.0280 RI 0. and second and fourth ranked measures. comparisons are between first and third ranked. First row presents p-value for comparison between first and second ranked measures.174 EBEI 0. Burgstahler and Dichev (1997) and Collins et al.000) CFO 0.174 EBEI 0. 1995). RI and EVA).266) (0. R p-value 6.1278 ' (0.041) (0. (4): D "b #b X /MVE #b X /MVE #e .0649 ' (0.0238 The underlying regressions in panel A constrain the coefficients to be equal across all firm-year observations. X"a given performance measure (CFO.G.C. and R MVE"the market value of equity three months after the beginning of the fiscal year.000) (0. X"a given performance measure (CFO.. (1997) provide evidence that loss firms have smaller earnings response coefficients than do profitable firms. earnings and operating cash flow (H ) 0 Rank order of R Observations (1) Relative information content (2) (3) (4) Panel A: Coefficient of positive and negative values of each performance measure constrained to be equal All firms Adj.000) (0.000) (0. R p-value 6. Because the value-relevance of the . / Journal of Accounting and Economics 24 (1997) 301–336 317 Table 2 Tests of the relative information content of EVA . where R   R R\  R\ R\ R D "market-adjusted returns.0732 ' (0.000) (0.000) Underlying regressions are from Eq. EBEI. The last row compares first and fourth ranked measures. second and third ranked measures and third and fourth ranked measures. See description of p-value below. Performance metrics are listed in order of R-squares from highest (on the left) to lowest (on the right).000) EVA 0.

(4).8%. Similar to the relative information content regressions in Eq. . we cannot support the Stern Stewart claim that EVA has greater information content than earnings. ATInt and CapChg. Thus.174 firm-year observations. In Section 5. 4. Biddle et al. We expect a negative association between returns and the two components representing non-negative capital costs. the relative information content results show no evidence of EVA (RI or CFO) dominating EBEI. RI and EVA) could also vary with their sign (O’Byrne.2. In contrast. However. RI and EVA) dominate CFO. adjusted Rs increase for each performance measure when allowing for separate coefficients on positive and negative values. The only difference is that RI and EVA are no longer statistically different from each other.C. Accrual and AcctAdj.318 G. coefficients (available from the authors) are generally larger (in absolute value) and more significant for positive values of X than for the negative values. we examine the sensitivity of these results to alternative specifications. this evidence points to earnings having higher relative information content than EVA. we discuss possible reasons why we fail to detect stronger value-relevance for EVA and RI. This increase is largest for the EBEI regression with adjusted R increasing from 9% to 12. the lagged terms are predicted to have the opposite sign (footnote 9). Consistent with prior research. 1996). the ranking of performance measures remains identical and statistical comparisons between regressions are nearly unchanged — earnings dominates each of the other three performance measures and all three (EBEI. Compared to R results reported above in Panel A. (7)  R\ R Predicted signs on each coefficient are provided below the variable labels. Taken as a whole. (6)  R\  R\  R\  R\ R Panel B of Table 2 presents results for regression (6) for the complete sample of 6. In Section 6. we repeat our tests for relative information content after partitioning each performance measure into positive and negative values: MktAdjRet "b #b X /MVE #b X /MVE R   R  R\  R  R\ #b X /MVE #b X /MVE #e . We expect a positive association between market-adjusted returns and the three components CFO. Incremental information content tests Table 3 presents results on the incremental information content of EVA components from regression (7): MktAdjRet "b #b CFO #b CFO #b Accrual R   R  R\  R #b Accrual #b ATInt #b ATInt  R\  R  R\ #b CapChg #b CapChg #b AcctAdj  R  R\  R #b AcctAdj #e . / Journal of Accounting and Economics 24 (1997) 301–336 other performance measures (CFO.

R Obs.221 2. capital charge. accounting adjsutments) and are shown in non-lagged forms as column headings.02 !8. Each independent variable is deflated by market value of equity three months after the beginning of the fiscal year.751 13.0907 G.43 1.72 3. Biddle et al. capital charge. accounting adjustments (H ) ' ATInt R # ! # # R\ ! ATInt CapChg R CapChg \ AccAdj AccAdj  \ ! Adj.53 128. ! Constant CFO R CFO R\ Accrual Accrual R R\ Predicted signs: !0.032) !0.63 3. p-values in parentheses represent non-directional F-tests of the null hypothesis of no incremental information content (hypothesis H ). operating accruals.391 0.48 6.013 1.C.357 0. after-tax interest.73 87.473 !0.000) 1.Table 3 Tests of incremental information content of EVA components: CFO. ' .61 (0.000) 0.824 16.09 !7.001) 0.192 !0.027) # ! # All firms t-stat F-stat p-value 6.055 3.772 !2.12 0.45 (0. operating accruals. after-tax interest expense. independent variables are components of EVA (CFO.270 !2.174 0.594 0.42 1. / Journal of Accounting and Economics 24 (1997) 301–336 319 Dependent variable"market-adjusted returns.83 (0.42 (0.55 (0.

05 level or better. The exception is the lagged term for AcctAdj. 9 out of 10 coefficients are in the predicted direction and significant in one-tail t-tests at the 0. Relative and incremental information content of EVA .C. 3. residual income. However. CFO. / Journal of Accounting and Economics 24 (1997) 301–336 In Panel A for the full sample. The relative sizes of the F-statistics suggest that CFO and Accrual make by far the largest incremental contributions to explaining market-adjusted returns. while ATInt. EBEI. these results suggest that.04% in Panel A of Table 2) and returns on EVA components (9. Fig. CapChg and AcctAdj exhibit much smaller incremental contributions. When combined with the relative information content findings above. RI and EVA. which is in the wrong direction. 3 uses a Venn diagram to summarize our findings on relative and incremental information content for the four information variables CFO. while EVA components offer some incremental information content beyond earnings components. the overall minuscule increase in adjusted R between the regression of returns on EBEI (9. RI and EVA protrude slightly from behind EBEI reflecting some limited incremental information content beyond earnings.05 level or better. EBEI exhibits the largest relative information content among the measures. . Fig. All of the two-tail F-tests are significant at the 0. earnings and operating cash flow. The size of each circle represents relative information content and the non-overlapping areas represent incremental information content.07% in Table 3) suggests that the economic significance of the incremental information content of the EVA components is slight.320 G. their contributions to the information content of EVA are not sufficient for EVA to provide greater relative information content than earnings. Biddle et al.

We repeat selected information content tests by: 1) partitioning annual observations into five. Thus market participants apparently did not begin using EVA for equity valuation immediately following the appearance of the Fortune article. Partitioning the sample into sub-periods Results reported in Tables 2 and 3 pool observations over the ten years 1984—1993. Sensitivity analyses and extensions In this section.045). However. CapChg and AcctAdj). CFO and Accrual are significant in every two-year period. 2) evaluating subsets of firms that claim to use EVA for internal business decisions. The earnings regression again has the highest R (11. 3) changing the return interval from one-year to five-years. there is no evidence of EVA (RI or CFO) dominating EBEI. In this section.01 level or better. Because of survivorship bias in the Stern Stewart data. we discuss a replication and extension of O’Byrne (1996). Biddle et al. In 1988—89 and 1990—91. we report relative and incremental information content tests on annual data grouped into five.C. We conclude with an overall assessment of the results of the sensitivity tests. non-overlapping. 1993).015 in the 1984—85 period to 1. EVA and RI are not statistically significant at conventional levels.1. where the dependent variable is the level of market value of the firm (rather than returns). In incremental information content tests. Finally.049) and CFO (p"0.072) but does outperform EVA (p"0. Taken together.481 in 1992—93. adjusted Rs are largest for EBEI in every two-year period. EBEI outperforms each of the other performance measures at the 0.006). We also consider the 606 observations following the September 1993 Fortune article that touted EVA as “The Real Key to Creating Wealth” (Tully. in 1986—87. In pairwise comparisons of relative information content.2%). Among the remaining EVA components (ATInt.083) but does outperform EVA (p"0.061) but not RI. in 1984—85 differences between EBEI. / Journal of Accounting and Economics 24 (1997) 301–336 321 5. and the evidence is suggestive of EBEI dominating EVA (p"0. the evidence points to earnings having higher relative information content in many sub-periods. EBEI does not outperform RI (p"0. firm-year observations increase from 1. Thus we again cannot support the Stern Stewart claim that EVA has greater information content than earnings. EBEI does not outperform RI (p"0.G. only 1 of 15 F-statistics is significant at the 5% level — AcctAdj in the 1984—85 sample period. and 4) changing the return interval from one-year (contemporaneous) returns to two-year (combined contemporaneous and oneyear ahead) returns. 5. In contrast. two-year test periods (instead of one ten-year period). non-overlapping. In 1992—93. Using a 5% cutoff. we examine the sensitivity of the basic results reported above to alternative specifications. Results for the period after release of the 1993 Fortune article again show strong support for the incremental information . two-year periods.

is a subset of the ‘Any’ sample. Thus. both CapChg and AcctAdj have significant F-statistics suggesting they make an incremental contribution to explaining contemporaneous security returns in years where firms have EVA-based .094 and 0. respectively)). none of the two-tail F-tests are significant for components unique to EVA. but EVA has the largest R for the ‘Comp Year’ sample. and only 3 out of 18 comparisons at the 10% level (EBEI'CFO for the ‘Any’ sub-sample (p"0. Firms in the ‘Any’ sample have disclosed that they use EVA (or some similar concept) sometime during the period studied — even if that use appears to be minimal. presumably. To examine this possibility. 5. also use it for performance measurement and/or decision making. Further. Biddle et al. we consider separately four sub-samples of firms that make some ‘use’ of EVA-like measures. it is conceivable that the association between EVA and returns is stronger for EVA adopters. in turn. The ‘Comp Year’ sample restricts observations in the ‘Comp’ sample to only those years in which an EVA-based compensation plan is in effect. In the small ‘Comp Year’ sample (n"35). none of the performance measures differ significantly in relative information content at the 5% level. investors may become more attuned to the measure for firms that adopt EVA.073). While earnings is not as dominant in these smaller sub-samples of EVA users.C. the ‘Comp Year’ sample is a subset of the ‘Comp’ sample. EBEI'RI for the ‘Any’ and ‘Performance’ sub-samples (p"0. With the exception of the ‘Comp Year’ group. / Journal of Accounting and Economics 24 (1997) 301–336 content of CFO and Accrual.2. which is a subset of the ‘Performance’ sample.’ ‘Performance’ and ‘Comp’ groups. We include all available data including years before the plan was implemented. The lower significance levels may be attributable in part to the smaller sample sizes used in these tests. 13 of 16 are significant for the CFO and Accrual components while only 1 of 24 are individually significant for the remaining EVA components. EBEI exhibits the largest Rs for the ‘Any. but little evidence for the incremental significance of the remaining EVA components. Table 5 reports tests of incremental information content for users of EVA-like performance measures. Table 4 reports the results of relative information content tests for firms using an EVA-like performance measure.65).059. Thus. However. Adopters of ‘E»A-like’ performance measures It is possible that firms adopt EVA at least in part because their past experience indicates a relatively strong relation between EVA and stock returns. Firms in the ‘Comp’ sample state that they use an EVA-like measure in senior management incentive compensation plans and thus.322 G. neither do the findings show EVA dominating earnings in its association with stock returns. Firms in the ‘Performance’ sample provide more detail about their use of an EVA-like measure for performance measurement and/or decision making. In one-tail t-tests of individual slope coefficients using a 5% cutoff (t"1. which.

all available firm-years are included.1152 Firms are categorized in their use of EVA as follows: E ‘Any’ represents all firms that have mentioned that they use EVA for performance evaluation and/or explicit incentive compensation — even if that use appears minimal.0386 ' (0.0262 ' (0.073) ‘Performance’ Adj. (4): D "b #b X /MVE #b X /MVE #e where R   R R\  R\ R\ R D "market-adjusted returns. Given the existence of a plan in any year.486) (3) EVA 0. and second and fourth ranked measures. ‘Comp’ is a subset of ‘Performance’. R p-value 35 EVA 0.211) RI 0. Biddle et al.0484 ' (0. RI.699) (0.481) (0.2644 ' (0.550) (4) 323 CFO 0. R p-value Obs.938) (2) RI 0. E ‘Performance’ represents those firms that have mentioned that they use EVA for performance measurement but do not disclose any use of EVA in their explicit incentive compensation plans. See description of p-values below.0239 RI 0.962) (0.735) (0.412) ‘Comp Year’ Adj.0461 ' (0. 626 (1) EBEI 0. and ‘Performance’ is a subset of ‘Any’.393) CFO 0. E ‘Comp’ respresents those firms that use EVA in their explicit incentive compensation plans and.834) (0. EBEI.855) EVA 0.059) ‘Comp’ Adj. for performance measurement. / Journal of Accounting and Economics 24 (1997) 301–336 Table 4 Tests of relative information content (H ): Sample partitioned by relative ‘use’ of EVA 0 Relative information content Rank order of R ‘Any’ Adj.0181 CFO 0.0799 ' (0. and R MVE"the market value of equity three months after the beginning of the fiscal year. On the next row. (4).352) (0.667) (0. second and third ranked measures and third and fourth ranked measures. CFO).3072 ' (0. Two-tailed p-values in parentheses represent tests of the null hyposthesis of no difference between pairwise comparisons of adjsuted R-squares (Biddle et al. 1995). presumably therefore.0317 RI 0. ‘Comp Year’ is a subset of ‘Comp’.481) (0. E ‘Comp Year’ represents a subset of observations from ‘Comp’ only including years where firms have an EVA-based compensation plan in place.G.765) (0.0523 ' (0. The last row compares first and fourth ranked measures. comparison are between first and third ranked. X"a given performance measure (EVA. Performance metrics are lsited in order of R-squares from underlying regression Eq. Statistical tests of differences in explantory power across performance measures are presented centered in parentheses below the adjusted R-squares.491) CFO 0.0220 ' (0.330) EBEI 0.C.2366 ' (0. R p-value 344 EBEI 0.094) (0. . Underlying regressions are from Eq.737) EVA 0.0306 ' (0. First row presents p-values for comparison between first and second ranked measures.867) (0.0292 ' (0. from highest (on the left) to lowest (on the right).278) (0.. R p-value 445 EBEI 0.

Biddle et al.843 !0.216) 0.791 !1.138 !0.896 4.488 1.129 !0.126 !0.036 0.69 1.047 !0.55 8.01 (0.010) .1054 Adj.562 !1.539) 0. R Obs.434 !1.123 !0.37 0.779) 0.34 (0.215 !0.835 0.09 !0.958 !2.324 Table 5 Tests of incremental information content of EVA components (H ): Sample partitioned by relative ‘use’ of EVA ' ATInt R # ! # R\ ! !1.59 (0.344 !0.557) !1.30 !2.45 (0.09 (0.05 !1.919 !0.05 2.000) 3. ! Constant CFO R CFO R\ Accrual Accrual R R\ # ! # Predicted signs: ‘Any’ 626 t-stat.08 0.54 (0.45 1. F-stat.043 0.000) !0.376 !1. / Journal of Accounting and Economics 24 (1997) 301–336 ‘Performance’ t-stat.72 (0.62 !0.54 1. p-value !0.396 0.61 (0.71 0.055 !1.35 1.709 2.23 4. F-stat.60 !0.08 !1.044 1.544) ATInt CapChg CapChg AcctAdj AcctAdj R R\ R R\ # 0.07 7.324 0.494 !1.41 10.C.76 0.868 !0.634) !0. F-stat.365 3.000) 0.023 0.368 0. p-value 344 !0.265) 0.0625 0.70 (0.41 0.70 0.425 1.40 (0.04 !3.62 (0.95 ! !0.624 5.61 4.0780 G.35 !0.46 (0.53 !3.136) 445 !0.235) !1.61 14.60 !0.17 (0.64 (0.00 0.001) ‘Comp’ t-stat.105 1.25 (0.009) 0.087 !0.52 4.012 !0. p-value !1.58 !1.51 1.

accounting adjustments) and are shown in non-lagged and lagged forms as column headings.87 (0.66 (0. independent variables are components of EVA (CFO.37 1.23 0. operating accruals.04 (0.  . ‘Comp’ is as a subset of ‘Performance’.687 !1. after-tax interest expense. / Journal of Accounting and Economics 24 (1997) 301–336 325 Firms are categorized in their use of EVA as follows: ‘Any’ represents all firms that have made any mention of using EVA for performance evaluation and/or explicit incentive compensation—even if that use appears minimal.26 (0. capital charge.35 !2. p-value !1.71 4.759 3. ‘Performance’ represents those firms that have mentioned that they use EVA for performance measurement but do not disclose any use of EVA in their explicit incentive compensation plans. P-values in parentheses represent non-directional F-tests of the null hypothesis of no incremental information content (hypothesis H ).167 !0.60 G.09 !1.61 2.841 !2.41) 0.178 !2.3344 ‘Comp year’ t-stat.130 0.05 !1.02 (0.62 1.70 3.00 0.430) 2.015 0.C. Dependent variable"market-adjusted returns.303) !0.154) !1. ‘Comp’ includes alll firm-year observations for those firms that use EVA in their explicit incentive compensation plans in any year.51 3.769 0. ‘Comp Year’ includes a subset of observations from ‘Comp’ for only those years where the EVA-based compensation plan is in effect. F-stat. and ‘Performance’ is a subset of ‘Any’. Biddle et al.122 !4. ‘Comp Year’ is a subset of ‘Comp’.031) !1.308 !1.240 !0.

In incremental information content tests. Stern Stewart reports its strongest results for EVA on five-year data (Stewart. and the unexpected signs on coefficients on CapChg. caution is warranted in drawing any inferences from this result due to: the small size of the ‘Comp Year’ sample. However.2%) followed by CFO (18. 1994). In Table 7 we report incremental information content of EVA components after extending the return interval from one year to five years. EVA (14. is summed over the most recent five-year period 1989—93  (for the non-lagged term) and summed over the prior five years. Five-year returns as the dependent variable In this section we extend the return interval from one year to five years. only one test period is reported in Table 6. because five-year data are less sensitive to the choice of expectations models. Regression (8) below is used to evaluate relative information content comparisons. It includes nonlagged and lagged terms similar to the annual return regression (4) and are analogous to the ‘level and changes’ specification discussed in Section 2.C. The differences in explanatory power between EBEI and each of the other three performance measures are highly significant. the surprising insignificant F-statistics on CFO and Accrual. Biddle et al.  We also evaluated the relative and incremental information content using changes in (rather than sums of) each performance measure over the five-year period.9%). 1984—88 (for the lagged term). CFO and Accrual are again highly significant but the results on components unique to EVA (CapChg and AcctAdj) are insignificant.326 G. . Again. other than weakly suggestive results for the ‘Comp Year’ sample. 5. these tests help address the possibility that the weaker performance of EVA is due to a poorer expectations model. In addition. Independent variables reflect ‘five-year sums’ in that each performance measure. 1991.3 and footnote 9. / Journal of Accounting and Economics 24 (1997) 301–336 compensation plans in effect. Results again show the earnings regression with the highest R (31. it does not appear users of EVA are adopting the concept because of its stronger association with stock returns. only AcctAdj for the 1988—93 sub-period was significant at the 5% level while none of the other components unique to EVA were significant in the predicted direction. (8)   R R\  R\ R\ R Since all ten years of data are used to examine the association between five-year returns and each performance measure. ‘5-year sums’: MktAdjRet R "b #b X /M»E #b X /M»E #e . X .3.9%). In relative information content tests. once again EBEI outperformed EVA.5%) and RI (10.

3%). Market value of the firm as the dependent variable Another claim made by Stern Stewart is EVA’s higher association with the market value of the firm.5. second and third ranked measures and third and fourth ranked measures. EBEI has significantly higher association with two-year returns (adjusted R"4. On the next row. . (8): Relative information content (2) CFO 0. Consistent with results in Table 2. Two-year (contemporaneous and one-year ahead) returns as the dependent variable To consider the possibility that equity market participants take longer to learn about and impound EVA. RI or EVA).000) (0. R EBEI.4%) than any of the other three information variables (whose Rs range from 2% to 2.051) (3) EVA 0.000) Underlying regression is from Eq. To test this claim.1446 ' (0. / Journal of Accounting and Economics 24 (1997) 301–336 Table 6 Tests of relative information content (H ): Returns measured over 5-year periods 0 Rank order of R ‘5-year sums’ Adj. Biddle et al. 1995). R p-value Obs..005) (0.G. 5. and MVE"market value of equity three months after the beginning of the fiscal year. respectively. 5. X"a given performance measure (CFO. 509 (1) EBEI 0. we extend the return interval from the one-year contemporaneous period used above to a two-year period that includes both the contemporaneous and subsequent year. comparisons are between first and third ranked. D "market-adjusted returns measured over five years.C. 1989—93 (non-lag) and 1948—88 (lagged) terms.3118 ' (0. The last row compares first and fourth ranked measures.1090 ‘5-year sums’: D "b #b X /MVE #b X /MVE #e .1888 ' (0.030) (4) 327 RI 0. and second and fourth ranked measures. R   R R\  R\ R\ R where is defined over the five-year intervals.264) (0. we replicate and extend a study  We also examined the change in ‘market value added’ (defined by Stern Stewart as firm market value less invested capital) as a dependent variable with qualitatively similar findings.4. p-value in parentheses represent two-tail tests of the null hypothesis of no difference between pairwise comparisons of adjusted R-squares (Biddle et al. First row present p-values for comparison between first and second ranked measures. and inconsistent with the conjecture that the market subsequently learns about the importance of EVA.

and MVE"market value of equity three months following the beginning of the fiscal year.56 33.01 (0. p-value !2.3241 ‘5-year sums’ t-stat.25 18.000) 5. 1989—93 (lagged) terms.39 # ! # 509 !0.21 0. D "market-adjusted returns.487 1.16 (0.C. CFO. CapChg and AcctAdj.42 1.659 0.. ! Constant CFO R CFO R\ Accrual Accrual R R\ Predicted signs !0. independent varibles (EVA components) are shown a column headings.447) !0.11 0.549 1.328 Table 7 Tests of incremental information content of EVA components (H ): Returns measured over five-year periods  ATInt R # ! # # ! R\ ! ATInt CapChg CapChg AcctAdj AcctAdj R R\ R R\ Adj.99 !0.  .275 0.64 2.75 (0.373 2. ATInt . Biddle et al. X "a given EVA component. Underlying regression as follows ‘5-year sums’: G.93 !2.065) 0. F-stat.01 (0. R   R R\  R\ R\  R R\  R\ R\  R R\  R\ R\ R where is defined over the five-year intervals. R R i.e.072 !0.731 1. Accrual. R Obs. R p-values in parentheses represent non-directional F-tests of the null hypothesis of no incremental information content (hypothesis H ).509 0.088 0.128 !0.089 !0. / Journal of Accounting and Economics 24 (1997) 301–336 D "b #b X /MVE #b X /MVE #b X /MVE #b X /MVE #2#b X /MVE #b X /MVE #e .54 7.17 0.986) !0.000) Dependent variable"market-adjusted returns. respectively.81 (0.

Second. 120). . First. Next. or equivalently. i. he makes a series of adjustments to the EVA regressions by: (1) allowing separate coefficients for positive and negative values of EVA. (2) including the natural log of capital in an attempt to capture differences in the way the market values firms of different sizes. he reports a much  # (EVA /k)/Capital #e  R R\ R # (NOPAT )/Capital #e   R R\ R (9) (10)  O’Byrne scales EVA by k and capital and NOPAT only by Capital. e unexplained residual error. There are three main differences between O’Byrne’s research and our tests reported above. Capital Stern Stewart’s definition of assets (net of depreciation) invesR\ ted in going-concern operating activities.  O’Byrne argues that a non-zero intercept makes predicted M» a function of Capital and therefore an EVA model in disguise. The initial relations tested in O’Byrne (before ‘adjustments’) are: M» /capital " R R\ M» /capital " R R\ where M»t/capital the market value of debt plus equity deflated by beginning of R\ period capital..e.G. None of these adjustments are made for the NOPAT regression.C. and (3) including 57 industry dummy variables in order to capture potential industry effects. EVA economic value added for year t. We cannot replicate results for free cash flow because O’Byrne (1996) does not provide a precise definition. After these adjustments. and in our view most importantly. contributed and retained debt and equity capital. NOPAT R k Stern Stewart’s estimate of the firm’s weighted average cost of capital. and O’Byrne further argues that a pure NOPAT model should be forced through the origin (p. at the beginning of period t. If so. O’Byrne uses market value of the firm (debt plus equity) as the dependent variable while we use market-adjusted returns. he draws inferences by comparing the magnitudes of Rs. while we draw inferences by relying on formal statistical tests of relative information content. O’Byrne makes a series of ‘adjustments’ only to the EVA regressions and uses Rs from these adjusted regressions to infer superiority of EVA over competing information variables. NOPA¹ —k (capital ) R R R\ net operating profits after tax for year t. Third. R O’Byrne compares Rs from the initial two models and reports 31% for the EVA model (9) and 33% for the NOPAT model (10). it would follow from our findings that EBEI is a better proxy for future EVA than is EVA. Biddle et al. / Journal of Accounting and Economics 24 (1997) 301–336 329 authored by Stern Stewart vice-president Stephen O’Byrne (1996).

the R of 49% is not significantly different from the EVA regression. In Table 8.843 firm-year observations obtained from Stern Stewart as described earlier. And.330 G. In contrast.’ EVA’s superiority disappears. Omitting industry dummies from Eq. unlike NOPAT or other earnings measures like net income or earnings per share. 5.1.4 and 5. Overall assessment of the sensitivity tests Considering jointly the sensitivity analyses of relative information content discussed in Sections 5. 125) concludes: “EVA.C. With this ‘level playing field. / Journal of Accounting and Economics 24 (1997) 301–336 higher R for the final model containing EVA (56%) than for the final model containing NOPAT (which. similar to results reported for our returns tests above. It should provide a better predictor of market value than other measures of operating performance.  These results are not directly comparable with the returns results above since they employ different functional forms and additional variables due to O’Byrne (1996).6. the EBEI regression has a significantly higher association with firm value (adjusted R"53%) than the EVA regression (50%). O’Byrne (1996) (p.3. 5. as we have shown. results in Table 8 provide no evidence of the EVA regression outperforming earnings in explaining deflated firm values. Thus. adjusted R is highest for EBEI in the remaining comparisons and EBEI significantly outperforms EVA in several sensitivity tests at the 5% level.5.  O’Byrne reports adjusted R of 42% for the EVA model omitting industry intercept dummies. it does provide a better predictor once we understand and adjust for two critical relationships between EVA and market value. 5. Biddle et al. 51% for EVA and 51% for NOPAT. falls to 17%). NOPAT and EBEI as competing performance measures and apply O’Byrne’s three adjustments to each variable (as described in regression Eq. (11) yields Rs of 53% for EBEI. After making the same adjustments to the NOPAT regression. (11) (while retaining scaling by k) yields Rs of 47% for EBEI.” Given the success of earnings in our returns tests discussed above. 5. 43% for EVA and 41% for NOPAT. because of the intercept restriction.2. (11) in a note to the table). we still find no evidence to support the Stern Stewart claim that EVA (or RI) outperform EBEI. we treat EVA. . is systematically linked to market value. In only one case (the ‘Comp Year’ group in Table 4) does EVA and/or RI have a higher R than EBEI and this difference is not statistically significant.  Omitting scaling by the cost of capital (k) from regression Eq. we add EBEI to the consideration set and replicate O’Byrne’s final model using 5. With all of O’Byrne’s adjustments (including industry dummies).

the analyses in Section 5 provide only limited evidence that components unique to EVA (i. Statistical tests of differences in explanatory power across performance measures are presented in parentheses below the adjusted R-squares. we find no evidence that EVA dominates earnings in its association with stock returns or firm values.413) (3) NOPAT 0. only two of the F-statistics and none of the t-statistics on CapChg and AcctAdj are significant at the 5% level. 0 NOPAT and EBEI where the dependent variable is the market value of the firm Relative information content Rank order of R Sample size Adj. Performance metrics are listed in order of R-squares from highest (on the left) to lowest (on the right). R p-value Obs.4886 In terms of incremental information content. 1995).G. comparisons are between first and third ranked. 5. NI) deflated by the firm’s cost of capital (as estimated by Stern Stewart). Summary and potential limitations Motivated by increased use in practice and increased interest in the media and among academics. ½"a given performance measure (EVA.843 (1) EBEI 0. CFO and Accruals)..000) (0.g. Tests based on Vuong (1989) are qualitatively identical.C. we examine the value-relevance of EVA and residual income compared to currently-mandated performance measures — earnings and cash flow from operations. and I is a dummy variable representing industry membership.000) Underlying regression is from O’Byrne (1996): M» /capital "b #b ½ /capital #b ½ /capital #b ln(capital ) R R\   R NMQ R\  R LCE R\  R\ #b I #e . There is little evidence to support the Stern Stewart claim . CapChg and AcctAdj) add to the information set that includes earnings (i. 6.e. / Journal of Accounting and Economics 24 (1997) 301–336 331 Table 8 Replication and extension of O’Byrne (1996): Tests of relative information content (H ) for EVA . (2) EVA 0. Thus.5321 ' (0. First row present p-values for comparison between first and second ranked measures and second and third ranked measures. respectively.4965 ' (0. (11) H H R where M»"market value of debt and equity.e. Biddle et al. capital "the firms’s R\ beginning of period contributed capital... e. where pos and neg refer to positive and negative values of the performance measure. from the sensitivity tests in Section 5. On the next row. See description of p-values below. NOPAT. Two-tailed p-values in parentheses represent tests of the null hypothesis of no difference between pairwise comparisons of adjusted R-squares (Biddle et al..

over five-year return intervals. For example. E Data needed to compute EVA are not easily estimated and the market does not have these data during our test period. the market should long ago have impounded these data. adjustments made by Stern Stewart may remove accruals that market participants use to infer firms’ future prospects. we use Stern Stewart’s publicly available database which does not include many custom adjustments they use for their clients.4. realized EVA may not outperform the current realizations of other performance measures such as earnings in proxying for future equity cash flows.3 do not lend support for the superiority of EVA over this longer return interval. if the cost of capital and the amount of capital are slow to change (or the changes are predictable months or years in advance). Equity valuation is ultimately the discounted present value of future equity cash flows (or dividends or RI or EVA). in most cases the evidence suggests that earnings outperforms EVA. On the contrary. E There exists little or no ‘surprise value’ in components unique to EVA including the capital charge and Stern Stewart’s accounting adjustments.. This potential issue is mitigated in tests that use alternative dependent variables (i.3. not future flows. However. this difference does not appear to be economically significant. Again the evidence does not support the superiority of EVA.C. / Journal of Accounting and Economics 24 (1997) 301–336 that EVA is superior to earnings in its association with stock returns or firm values. while the charge for capital and Stern Stewart’s adjustments for accounting ‘distortions’ show some marginal evidence of being incrementally important. E Stern Stewart’s estimates of the charge for capital and accounting adjustments may contain measurement error relative to what the market is using to value firms. Possible reasons why we do not detect stronger value-relevance for EVA include: E Our research design uses current realizations.5). five-year return intervals in Section 5. This is similar to the rationale used to explain why EBEI generally outperforms CFO in relative information content. These could be discretionary accruals that managers use to ‘signal’ future prospects or nondiscretionary accruals that are by-products of .e. and results reported in Section 5. Further. of each performance measure. Recall that we assume that the market has access to sufficient data within three months of a firm’s fiscal year end such that EVA (and its components) can be reliably estimated by that time. Even if EVA is a good proxy for economic profits. E In attempting to approximate economic profits.332 G. Further. and firm values in Section 5. two-year return intervals that include both contemporaneous and one-year ahead returns in Section 5. the opportunity for surprise should be larger. Biddle et al. In no case does EVA significantly outperform EBEI in tests of relative information content.

the resulting metric might closely resemble earnings (or what earnings might become). Wu (1997) presents an agency model in which firms will optimally choose accounting adjustments for internal performance metrics that serve to reduce their correlation with stock returns. or subtract from. E In violation of our maintained hypothesis of semi-strong market efficiency. / Journal of Accounting and Economics 24 (1997) 301–336 333 the accounting process. However.C. Until further research can be conducted. (1997) report evidence consistent with discretionary accruals increasing the informativeness of earnings. As more data become available. this would subject EVA to many of the same legal and regulatory influences. and as a consequence. ex ante. it is possible that Stern Stewart obtains a measure that is closer in level to economic profits (than say EBEI). future studies will be able to assess whether market participants have come to appreciate EVA. Thus.  Collins and DeAngelo (1990). performance measurement and incentive compensation. and despite its alleged advantages for internal decision making.G. our conclusion is that.  Wallace (1996. capitalizing R&D and marketing costs should only add to EVA’s information content given both are generally expensed in the determination of earnings. Biddle et al. and Hunt et al. information content. Subramanyam (1996). It also is possible to imagine a new equilibrium in which firms would disclose EVA rather than earnings. consistent with the notion of ‘earnings myopia’. by estimating taxes paid in cash (rather than tax expense). it does not dominate earnings in its association with stock market returns for the sample firms and period studied. we do not anticipate that EVA will displace earnings for financial reporting purposes. 1998) reports that some adopters of EVA feel they must still base their external performance on earnings because this is the measure on which financial analysts continue to focus. EVA may lose information content by removing value-relevant deferred tax accruals. but at the same time reduces its association with stock returns. the market may have failed to recognize the reporting benefits of EVA through the period we study. although for some firms EVA may be an effective tool for internal decision making. For this reason. To the contrary. In contrast. An avenue for future research suggested by the findings of this study is to examine more closely which components of EVA and earnings contribute to. in constructing EVA. our evidence suggests that earnings generally dominates EVA in value-relevance to market participants. . and in contrast to claims by Stern Stewart. Research at this level of detail requires data that are currently unavailable from Stern Stewart on individual adjustments used in the calculation of EVA. For example.

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