Investigating the Explanatory Power of Economic Profits (Eva®) versus Accounting Profits on Stock Returns as a Measure of Shareholders Wealth Creation. An Empirical Study of the FTSE 100.

Abstract

The main motivation behind this study is to find out if Economic Value Added (EVA®) is truly the best predictor of share returns and if shareholders should rely on it solely and forget accounting measures as claimed by its founders (Stern Stewart & Co.). This research investigates the superiority of Economic Profits (EVA®, EVA® spread and EVA® momentum) over traditional accounting measures (ROA, ROE, EPS, Net Income and NOPAT) in explaining stock returns and also aims to find out which is truly the best predictor of share returns. To achieve this, economic measures and accounting measures were used as the independent variables and stock returns as the dependent variable. Three different regression tests were applied: a panel data regression testing economic measures and accounting measures separately; a stepwise panel regression test and another panel regression test testing all of the independent variables along with a post-hoc chi-square analysis. These tests were applied to 25 publicly listed companies on the FTSE100 from 2009 to 2012. From both the panel data regression and the stepwise regression it was found that economic measures do not dominate earnings and it was also found that ROA has a stronger explanatory power than all of the economic measures. However, EVA® momentum was also found to have a strong positive impact on share returns, all of the other tested variables were found to be statistically insignificant. From the third test it was also found that the ROA had the highest explanatory power, followed by EVA® and EVA® momentum; the rest of the variables were also found to be statistically insignificant. Moreover, this study found that 76% of share returns are explained by different factors other than both economic and accounting measures combined. This study concludes that EVA® is not the best predictor of share returns and shareholders should not rely on it solely but should also rely on traditional accounting measures, especially the ROA. Furthermore, shareholders should also take into consideration different factors such as technical, economic and political analysis when undertaking investment decisions as share returns are not entirely explained by performance measures.

Keywords: EVA, EVA momentum, Economic Profits, Accounting Profits,Economic Value Added, Value Based Performance Measures, EVA®