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Abstract:
Economic Value Added (EVA) has attracted considerable attention as an alternative to traditional accounting earnings for use in both valuation and incentive compensation. With a host of consultants now marketing related metrics, numerous claims have been made - most based on anecdotal evidence or in-house studies. This paper summarizes independent evidence regarding EVA's alleged advantages. We begin by reviewing the theory that links the underlying concept of residual income to shareholder value. Second, we discuss how Stern Stewart modifies residual income to produce its proprietary EVA metric and show how median EVA compares with residual income, net income and operating cash flows over the period 1988-97. Third, we examine the claim that EVA is more closely associated with stock returns and firm value than is net income. The evidence indicates that EVA does not dominate net income in associations with stock returns and firm values. Fourth, we examine a second claim that compensation plans based on residual income motivate managers to take actions consistent with increasing shareholder value. Here, the independent evidence suggests that managers do respond to residual income-based incentives. Finally, we discuss how a metric such as EVA can be useful for internal incentive purposes even if it conveys little news to market participants regarding the firm's valuation.

Abstract:
Accountants and economists have claimed that residual income has attributes superior to reported accounting earnings. In recent years, Stern Stewart & Co. has successfully marketed a variant of residual income ("economic value added"; or EVA?) to U.S. and international corporations. The purpose of this paper is to 1) empirically test assertions that EVA is more highly associated with stock market returns and firm values than are earnings and cash from operations, and 2) evaluate which components of EVA, if any, are contributing to its association with stock returns.

We first compare the relative information content of residual income and EVA versus two currently mandated performance measures, earnings and cash from operations. Results for the full sample suggest that, while each measure is individually significant, earnings is more highly associated with market-adjusted returns than is residual income, EVA, or cash from operations. Next, we conduct incremental information content tests on components of EVA (e.g., cash from operations, operating accruals, capital charge, and accounting "adjustments";). Results suggest that cash from operations and accruals are of primary importance while EVA components are statistically significant only in some samples. Finally, we conduct sensitivity analyses by repeating our tests using: a) subsets of firms categorized into "firm-types" by Stern Stewart; b) positive and negative values of each independent variable to allow the regression coefficients to differ; c) subsets of firms that report using EVA for internal business decisions; and d) five-year return intervals. Considered together, these results do not support claims that EVA dominates earnings in relative information content, and suggest rather that earnings generally outperforms EVA.

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. Considered together, these results do not support claims that EVA dominates earnings in relative information content, and suggest rather that earnings generally outperforms EVA.

Value-relevance, relative information content, incremental information content, firm market value, economic value added, EVA, residual income, economic profits, earnings, cash from operations, charge for capital.

Abstract:
This study examines executive compensation determinants in the U.S. financial services sector. Multiple theories of executive pay are discussed and tested using a relatively homogenous sample. We perform an in-depth look at the corporate governance and ownership structure of the companies selected. The analysis is conducted for the financial sector as a whole and for each of three sub-groups: commercial banks, brokerage and other non-depository institutions, and insurance companies. Variables that proxy for managerial strategic discretion and task complexity are found to best explain CEO compensation. Corporate governance, including board characteristics and external ownership, is the second leading determinant of pay variation, while firm performance and CEO specific characteristics seem to play the least role. We explore the simultaneous relationship between compensation, firm performance, and board strength and find evidence that the board of directors provides a monitoring function and that a strong board appears to be a substitute with incentive compensation for aligning incentives. These findings, when viewed with subsequent firm performance, support an efficient contracting argument.

Abstract:
In this paper, we examine the relative information content of two cash earnings measures (earnings with amortization of intangibles added back and earnings before interest, taxes, depreciation, and amortization), one traditional accrual accounting earnings measure (earnings before extraordinary items), and one traditional cash flow measure (cash flow from operations). Our research is motivated by the increasing use of these cash earnings disclsoures and the perceived additional value they provide. Overall, we find results consistent with previous research that nothing beats accrual earnings in its ability to explain market-adjusted returns. In addition, and again consistent with prior literature, we find that as each measure moves further away from accrual accounting earnings and closer to cash flows, the explanatory power of the measure decreases. We do find, however, that the information content rank ordering of our four measures reverse when we perform our tests on only firms' loss-year observations, although there is no statistical significance between the measures in their relative information content. We further explore the loss-year sub-sample by examining cases in which the loss includes a large amortization charge. Within this sub-sample, the cash flow measures dominate. In fact, each of the two cash earnings measures provides significantly greater information content than does accounting earnings. The provides evidence that these disclosures may have value in certain settings.

Abstract:
In 1993, Section 162(m) of the U.S. Internal Revenue Code was passed into law. The intent of this law was to reign in outsized executive compensation by eliminating the tax-deductibility of executive compensation above $1 million unless the excess compensation was performance-based. One unintended consequence of the legislation was that executives' total compensation actually increased in the post-1993 period. One compensation package component whose use dramatically increased, as expected, following the adoption of Section 162(m) was performance-based employee stock options. Employee stock options, however, have unintended consequences of their own. For example, the economic value of performance-based stock options may be influenced by executive decision-making when the options are valued using the Black-Scholes model or some variant thereof. This study investigates whether the incentives embedded in stock options are associated with such unintended consequences as increased market volatility and reduced dividend yields. Using data from the Standard and Poor's ExecuComp Database, empirical results for the period 1992 through 2004 reveal a significant, positive relation between the quantity of options held by CEOs and share price volatility, and a significant, negative relation between the quantity of options held by CEOs and dividend yields. These results suggest that executives used their discretion to positively impact the performance-based component of their compensation through actions affecting share price volatility and dividend yields, assumptions implicit in option-valuation models.

Executive compensation, Employee stock options, IRC Section 162(m)

Abstract:
Nevertheless, the importance and difficulty of balancing stakeholder interests against the overarching goal of efficiency and value maximization cannot be overstated. As with any corporate investment, each dollar of investment in a corporate stakeholder group should be justified by at least a dollar of expected return over a finite time horizon. By practicing this kind of “enlightened value maximization,” to borrow Michael Jensen's phrase, management is likely to end up increasing not only its returns to shareholders, but the size of the corporate pie that is divided among all its stakeholders. Viewed in this light, CSR and value maximization have the potential to be complementary undertakings that result in a virtuous circle in which “doing good” helps companies do well, and doing well provides the wherewithal to do more good. Although often viewed as inconsistent with the corporate goal of value maximization, the corporate social responsibility (CSR) movement can add value by helping companies develop and maintain their reputations for fair dealing with each of their important non-investor stakeholder groups, including employees, suppliers, and local communities. Such “reputational capital” in turn helps reinforce the commitment of those stakeholders through what amount to informal or implicit contracts - contracts that are often critical to a company's long-run success.

Nevertheless, the importance and difficulty of balancing stakeholder interests against the overarching goal of efficiency and value maximization cannot be overstated. As with any corporate investment, each dollar of investment in a corporate stakeholder group should be justified by at least a dollar of expected return over a finite time horizon. By practicing this kind of “enlightened value maximization,” to borrow Michael Jensen's phrase, management is likely to end up increasing not only its returns to shareholders, but the size of the corporate pie that is divided among all its stakeholders. Viewed in this light, CSR and value maximization have the potential to be complementary undertakings that result in a virtuous circle in which “doing good” helps companies do well, and doing well provides the wherewithal to do more good.

Abstract:
Corporate Social Responsibility, or "CSR," has recently become a subject of study by financial economists. While there is no shortage of anecdotal evidence to support all variety of positions, broad-based statistical evidence about the CSR movement is in short supply. This article presents some new empirical evidence that aims to answer three related questions about CSR: First, are corporations increasing their "investment" in what is considered socially responsible behavior? Second, does corporate investment in social responsibility affect a company's financial performance and shareholder value? Third, why do companies invest in CSR: to increase shareholder value, or to uphold a "moral" commitment to non-investor stakeholders and "society"?

Using a social responsibility metric that measures the net CSR strengths (i.e., strengths less concerns) of each S&P 500 and Domini 400 company, the authors report that the average net CSR for both indexes decreased during the 15-year period (1991-2005) of the study - though the Domini 400, as might be expected, experienced a smaller decline. The authors also report that corporate strengths have increased, on average, but at a slower rate than the "concerns," which suggests that corporate CSR efforts may be aimed at a moving target with steadily rising expectations and requirements.

Second, the authors report that companies with more CSR strengths or fewer CSR weaknesses produced higher ROA over the same 15-year period. The authors' findings here suggest a "circular" causality in which profitable companies are more likely to invest in CSR initiatives to begin with, but then find their performance further improved by such investment.

Third, the authors' findings suggest that most companies devote resources to CSR initiatives as a means of maximizing long-run value rather than out of a prior commitment to stakeholders. More specifically, the study shows that companies appear to invest more heavily to build their CSR strengths than to eliminate their CSR concerns. And as the authors conclude, this behavior is consistent with a strategy of using CSR as a form of "risk management" that promotes corporate strengths in order to limit the potential negative effects of - perhaps by diverting attention from - their weaknesses.

CSR, Corporate Social Responsibility, Stakeholder Theory, Profitability

Abstract:
It has been argued that compensation plans based on a residual income performance measure help mitigate dysfunctional behavior associated with plans based on traditional accounting measures. This paper develops and empirically tests hypothesized managerial actions associated with residual income-based performance measure incentives. A sample of forty firms that began using a residual income performance measure in their compensation plans is compared to a matched-pairs control sample of firms that continue to use traditional accounting earnings-based incentives. The results generally support the hypothesized managerial actions. Overall, I find that "you get what you measure and reward."

Abstract:
In this paper we study the pay-for-performance relation for top executives in the computer industry and compare these findings with a large sample of firms from other manufacturing and service industries. For both CEO and the remaining four most highly compensated executives of the firm, we examine whether superior performance is rewarded by higher levels of compensation and whether the form and level of compensation affects future performance. We find cash-based compensation, such as salary and bonus, is influenced by performance. Depending on the growth orientation of the company, pay is tied either to accounting measures of performance or to stock return. Such a dichotomy also prevails with respect to the degree of managerial ownership separation. In contrast, stock-based compensation such as options and restricted stock awards is not reflective of performance, irrespective of growth orientation or ownership structure. Two other interesting findings are that the prevalent use of stock-based compensation in the computer industry does not appear to be the result of computer firms being "cash starved." In addition, stock-based compensation does not appear to lead to larger executive stock ownership, as is widely believed.

Abstract:
It has been asserted that compensation plans based on a residual income performance measure help mitigate dysfunctional behavior associated with plans based on accounting earnings. This assertion is empirically tested by selecting a sample of firms that have begun using a residual income performance measure in their compensation plans and comparing their performance to a control sample of firms that continue to use traditional accounting earnings-based incentives. Relative to the control firms, these firms 1) decreased their new investment and increased their dispositions of assets, 2) increased their shareholder payouts, and 3) more efficiently used their assets. Further, evidence suggests that market participants respond favorably to adoption of residual income-based compensation plans. For the sample of firms studied, I interpret the results as being consistent with a residual income-based performance measure providing incentives for managers to act more like owners, thus mitigating the inherent conflict between managers and shareholders.