Operating Income, Residual Income and EVA: Which Metric Is More Value Relevant-A Comment

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This comment concerns two main issues that have been presented and discussed by Chen and Dodd (2001). Firstly, epistemologically, economic value added (EVA) is of dubious worth because it is construct deficient in an efficient market hypothesis (EMH) world and also in a non-efficient market hypothesis (non-EMH) world. This has important implications for valuations and value creation. Moreover, the transmission mechanism of EVA into market value added (MVA) is problematic. Secondly, contrary to the importance that Chen and Dodd (2001) ascribe to the relevance of accounting information, there is a growing body of research that shows that accounting information is becoming progressively less relevant to stock returns and stock price changes, and this trend is expected to continue.

THE EMH, EPISTEMICS AND EVA

Epistemologically, EVA is a non sequitur because it is construct deficient in both EMH and non-EMH-worlds. Furthermore, the fundamental economic and financial factors that constitute the main drivers of EVA have been shown to have only a minor impact on changes in share price, and hence share returns.

EVA in an EMH-World--a Financial Fiction

In an EMH-world, where assets plot on the Security Market Line (SML) or Capital Market Line (CML), and asset prices (market prices) correspond to asset values (intrinsic values), it is not possible to meaningfully talk about a measure such as EVA. On the SML and CML, by definition net present value (NPV) equals zero and the required rate of return (PER) or cost of capital equals the internal rate of return (IRR), in which case EVA must equal zero. Since EVA measures the difference between RRR and IRR, in an EMH-world EVA is attempting to measure a quantum that by definition cannot exist, except perhaps as noise. Arbitrage and competitive action ensure that abnormal profit cannot consistently occur. If the phenomenon of EVA were to be observed, its occurrence would be random, statistically non-significant, would not be serially correlated and, on the average, positive-EVA would be offset by negative-EVA. In an EMH-world, it is not possible to consistently earn excess returns (i.e., abnormal or super-profits) e xcept at the price of higher risk, measured by the beta coefficient. Thus, within the logic of the EMH, EVA is a fiction.

In an EMH-world, EVA would be impounded in an unbiased way into stock prices so that prices corresponded to intrinsic value. In other words, the market would recognize the impact of EVA and would impound it into stock price. The increase in stock price would create market value and is known as MVA. If EVA, an internal metric of performance, is not transmitted into MVA, an external metric of performance, shareholders do not benefit from improvements in EVA as far as asset pricing is concerned. The question of the transmission of EVA into MVA is an area that requires additional research. Since EVA is concerned with economic and financial fundamentals, it is important to know to what extent changes in EVA will move stock price. The question of what moves stock prices has been investigated for a considerable period of time, and the findings suggest that financial and economic fundamentals play only a minor role in the changes in asset prices (Cutler et al,, 1989; Haugen et al., 1991; Shiller, 1981; Roll, 1984, 19 88; Frankel and Meese, 1989).

EVA in a Non-EMH-World

There are three issues I would like to raise with regards to EVA in a nonEMH-world, namely, the validity of using the capital asset pricing model (CAPM) and beta, the matter of what moves stock prices and hence MVA, and the matter of dividends and earnings in relation to stock price.

The validity of using the CAPM. In a non-EMH world, the validity of using the CAPM as the basis for the calculation of EVA is questionable because the CAPM is derived from the EMH and is dependant upon the existence and functioning of the EMH. …