Solving the Value Metrics Puzzle

Abstract

On theoretical grounds, shareholder returns should be better explained by some version of residual income (operating profit minus a capital charge) than by a profit number solely. However, empirical evidence indicates the opposite. We first investigate whether this 'value metrics puzzle' may be due to the measurement problems met when quantifying the cost of capital. Our results suggest that these problems do indeed negatively affect the explanatory power of residual income. Secondly, after robustness handling the results further improve and we find strong evidence that 'residual income beats earnings'. A third finding is that the market-derived way of determining the cost of capital generally dominates the CAPM-based one.

Keywords: Performance measure selection, cost of capital, CAPM

JEL Classification: G30, G32, M40, M50