Eva Financial Systems: Management Perspectives

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EVA Financial Systems: Management Perspectives

James S. Wallace University of California, Irvine Graduate School of Management Irvine, CA 92697-3125 jswallac@uci.edu October, 1996

Abstract This paper studies the management actions associated with a change to an EVA-based compensation system. A questionnaire was sent to a member of top management of seventy-six firms that have adopted EVA type performance measures, forty of these firms having included the measure in their incentive compensation. Based on the respondents’ answers, EVA performance measures appear to help align the interests of management with those of the firm’s shareholders with the emphasis shifting from bottom-line earnings to earning more than the cost of employed capital. The responses are compared with prior empirical work. In most cases, the observed results of management actions is consistent with the responses from this survey.

This paper resulted from work done for my dissertation from the University of Washington. I wish to thank my committee members Gary Biddle, Robert Bowen, Eric Noreen, Terry Shevlin, and Naomi Soderstrom. I also wish to thank the participants in the University of California, Irvine, and the University of Washington workshops.

EVA Financial Systems: Management Perspectives

Abstract
This paper studies the management actions associated with a change to an EVA-based compensation system. A questionnaire was sent to a member of top management of seventy-six firms that have adopted EVA type performance measures, forty of these firms having included the measure in their incentive compensation. Based on the respondents’ answers, EVA performance measures appear to help align the interests of management with those of the firm’s shareholders with the emphasis shifting from bottom-line earnings to earning more than the cost of employed capital. The responses are compared with prior empirical work. In most cases, the observed results of management actions is consistent with the responses from this survey.

Introduction
New management tools seem to be introduced continuously, almost always being hailed as the cure to most, if not all, of the problems affecting business. Just-in-time inventory and management, total quality management, theory of constraints, reengineering, balanced scorecard, and the list goes on. Economic value added (EVA), a proprietary product of the consulting firm Stern Stewart & Co., is no exception to the rule of promising great things to those who follow its gospel. One only needs to read headlines such as “The Real Key to Creating Wealth” where Fortune describes EVA as “today’s hottest financial idea and getting hotter” to get an idea of the enthusiasm surrounding the concept [Tully (1993)]. Fortune appears to be accurate in its assessment of the popularity of EVA with hundreds of firms either implementing an EVA like system, or at least considering implementation. Unlike some managerial innovations, EVA is not a new concept. EVA is essentially residual income modified for today’s environment. References to residual

EVA Financial Systems: Management Perspectives

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income date back to the 1700’s.1 Stern Stewart have been successful in updating and renaming the residual income measure to address what they consider several shortcomings of the traditional GAAP measure of earnings in addition to the lack of a charge for equity capital. 2 Perhaps one reason that EVA has generated the degree of excitement that it has is due to some of the claims being made by its proponents. Statements such as “EVA is almost 50% better than its closest accounting-based competitor in explaining changes in shareholder wealth.” “Earnings, earnings per share, and earnings growth are misleading measures of corporate performance.” “The best practical periodic performance measure is economic value added (EVA)” [Stewart (1991)]. EVA has been described as a measure capable of giving its users, both...
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