Academic journal article IUP Journal of Applied Finance

Does Economic Profit Beat Earnings? Evidence from Brazil

Academic journal article IUP Journal of Applied Finance

Does Economic Profit Beat Earnings? Evidence from Brazil

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

In simple terms, the Economic Profit (EP) reflects the net operating income after the creditors' and shareholders' cost of capital. The Economic Value Added (EVA®) is the most common EP measurement-a registered trademark of Stern Stewart & Co.-which is used, for instance, to manage the value generated by business units to evaluate their economic performance and to stimulate their administrators.

Since EVA was created, and was especially based on articles written by researchers, at that time, connected to Stern Stewart & Co., like Stewart (1994) and O'Byrne (1996), it is suggested that the other indicators should be replaced by EVA. It is argued, for example, that EVA is "almost 50% better than its closest accounting-based competitor in explaining changes in shareholder wealth" (Stewart, 1994, p. 75).

The studies performed in the US have diverging conclusions. O'Byrne (1996) concluded that the EVA is better than other measurements such as the Net Operating Profit After Taxes (NOPAT) and cash flow, while Biddle et al. (1997) produced evidences to the contrary.

Feltham et al. (2004), when analyzing the article written by Biddle et al. (1997), reapplied the tests for different periods and databases, concluding that EVA better explains the return on shares, thus reopening the debate: 'Does EVA Beat Earnings?'-the question posed in the title of the Biddle et al.'s (1997) study. "Our study indicates that it does, suggesting that the debate should be reopened," conclude Feltham et al. (2004, p. 88).

In Japan, Tsuji (2006) concluded that a company's market value is more closely related to indicators such as cash flow and other operational measures than to EVA. Kyriazis and Anastassis (2007) concluded (based on the companies listed on the Athens Stock Exchange) that net and operating profits seem to be more value relevant than EVA to explain the return on shares and companies' market value. Furthermore, the authors said that EVA adds only marginally to the information in the accounting profit.

Literature Review

Recognized by the economists since 1770 (Biddle et al., 1999), the EP concept (or residual income) is based on the premise that a company generates value to its owners when it is capable of earning, over the invested capital, more than its cost of capital.

The EVA is a specific EP methodology owned by Stern Stewart & Co., calculated as in Equation (1). What makes it specific is a series of adjustments to the accounting standards and the estimation of the capital cost.

... (1)

where NOPAT is the net operating profit after taxes calculated as the operating profit x(1 - t); WACC is the weighted average cost of capital; IC is the invested capital by all investors, i.e., creditors and shareholders; and t is the corporate tax rate.

One of EVA's validity tests is to measure how much it explains the company's market value or its variation, as discussed by Abate et al. (2004) and Feltham et al. (2004). The question is which indicator is better associated with the company's value: an EP measure (EVA or other EP measure) versus an accounting measure (the net income or operating income)?

The studies involving NI based on a one-year return period present an R2 lower than 10% (Easton et al., 1992). Numerous authors tried to improve this relation, such as Easton et al. (1992), who extended the return period to 10 years, given that some relevant event that impacts the value of a company may be accounted for in the NI during the subsequent periods, and not in the same period during which the event has occurred. The tests performed by them took into consideration companies which had the necessary information provided in the 1987 version of the Compustat Annual Industrial Files, and evidenced a higher R2 for longer periods: 5% for one year, 10% for two years, 33% for five years and 63% for 10 years. The authors concluded that "earnings are more likely to reflect the value-relevant events and their effect on value changes over longer periods" (Easton et al. …

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