IS ECONOMIC VALUE ADDED SUPERIOR TO EARNINGS AND CASH FLOWS IN EXPLAINING MARKET VALUE ADDED? AN EMPIRICAL STUDY.

• Author: Obaidat, Ahmad N.

INTRODUCTION

Due to the changes in the business environment, business community is looking for more powerful performance measures that overcome the problems associated with the traditional accounting measures, in terms of emphasizing shareholders value maximization, which has become the obsession for managers and capital providers. The traditional accounting measures have been criticized because they failed to represent faithfully: the factors that drive shareholder value (Chari, 2009), profitability (Al-Mamun & Abu-Mansor, 2012), and the financial situation of the firms (Bluszcz, Kijewska & Sojda, 2015).

In recent years, firms have been focusing on creating value for their shareholders (Sirbu, 2012), and the value maximization has become a well accepted objective among them (Bhasin, 2013), so the attention should be paid to the elements of shareholders value creation (Ganea, 2015). In this regard, new performance measures have been introduced (Abdeen & Haight, 2002; Chari, 2009), such as Economic Value Added (EVA), Market Value Added (MVA), Cash Flow Return on Investment (CFROI), Total Shareholder Return (TSR), Shareholder Value Added (SVA), and Value Added Management (VAM).

EVA, which is considered one of the most popular value indicator measure, is a trade mark developed in the early 1990s by Stern Stewart & Co., a New York based consulting firm that claimed that EVA is superior to traditional accounting measures in measuring shareholder value. The idea behind EVA is that the firm adds value to shareholders if it earns more than the cost of capital employed, where the cost of capital includes the total costs of borrowed capital and equity capital. In other words, EVA is the profit earned by the firm minus the cost of capital. If EVA is positive, the firm is creating value for its shareholders, and if it is negative, the firm is destroying value. So, EVA differs in that it considers the cost of all capital employed, and not just the cost of borrowed capital as the traditional accounting measures do.

Many researchers considered EVA helpful in: indicating how successful a firm is in creating value for shareholders (Epstein & Young, 1998), making financial decision, (Goldberg, 1999), analyzing capital budget and securities (Kramer & Peters, 2001), valuing investments (Sparling & Turve, 2003), enhancing business environment (Tsuji, 2006), measuring performance (Sharma & Kumar, 2012), identifying investment opportunities (Bhasin, 2013) and determining remuneration policy (Ganea, 2015).

Some other researchers doubted that EVA is a new discovery. Kyriazis and Anastassis (2007), Bhasin (2013), and Nagarajan (2015) argued that a similar concept had been contemplated by economists such as Alfred Marshall for many years before that, particularly in 1890, who spoke about the economic profit, in terms of the real profit that firms make when it covers the cost of its invested capital. Also the Finnish academics and financial press discussed this concept in the early 1970s. In the same context, Goldberg (1999), Keys, Azamhuzjaev & Mackey (2001), De Wet (2005), and Nagarajan (2015) asserted that EVA is a relatively recent variant of residual income, an older financial measure that did not get wide publicity and was abandoned by firms years ago, whereas the difference between EVA and residual income lies in the various adjustments in the financial statements suggested by Stern Stewart & Co.

These adjustments aimed to remove the distortions in the accounting profit caused by accounting rules (Machuga, Pfeiffer, & Verma, 2002), and because Stern Stewart & Co. suggested more than 160 adjustments, many researchers criticized EVA. Goldberg (1999) argued that the cost of EVA may exceed its benefits. Keys, Azamhuzjaev & Mackey (2001) argued that EVA calculation is very complex and too difficult to understand, especially the calculation of the cost of capital. Bhasin (2013) argued that the complex calculation of EVA may lead to calculation errors that lead to misleading results.

Regardless of these criticisms for EVA, Large well known firms including Coca-Cola, Polaroid, Sprint Corporation, AT&T, CSX, DuPont, Eli Lilly, Quaker Oats, Briggs & Stratton, and Toys 'R Us have utilized EVA in investment decisions, capital reallocation, and the performance evaluation (Kramer & Pushner, 1997; Tortella & Brusco, 2003; Al-Mamun & Abu-Mansor, 2012). Recently, Stancu et al. (2017) have asserted that "EVA is the most widely used indicator by firms and financial advisors to measure the company's performance".

While EVA is considered an internal single-period measure of firm performance, MVA is a more forward looking measure (Kramer & Pushner, 1997). MVA is considered a cumulative measure of the value created by the firm (Kramer & Peters, 2001), which is the difference between the market value and the book value of capital (Sparling & Turve, 2003), and from investors' point of view, MVA is the best external measure of a firm's performance (De Wet, 2005).

There is a general belief that, in order to maximize shareholders value, firms should maximize MVA, and the best way to do so is by maximizing EVA (De Wet & Hall, 2004) because MVA is the sum of all future EVAs (Poornima, Narayan, & Reddy, 2015). In this regard, Khan, Aleemi, and Qureshi (2016) argued that the debate is still on about the superiority of EVA over the traditional accounting measures.

Whereas the previous empirical studies revealed controversial results regarding which is superior in explaining MVA; is it EVA or the traditional accounting measures? (Altaf, 2016).

This study investigates if Economic Value Added (EVA) is superior to Net Operating Profit after Tax (NOPAT) and Net Cash Flow (NCF) in explaining the change in the Market Value Added (MVA) of the non-financial firms listed on Amman Stock Exchange (ASE) for the year 2016. The results indicated that NCF has the strongest power in explaining the change in MVA, followed by EVA. The results also indicated that the NOPAT does not add additional significant explanatory power to NCF and EVA in explaining the change in MVA.

LITERATURE REVIEW

After the introduction of EVA as a performance measure used in assessing firm's ability to create value for shareholders, studies have revealed controversial results regarding the superiority of EVA over the traditional accounting measures. The most related previous studies supporting the superiority of EVA are presented next, followed by the most related previous studies that do not support the superiority of EVA.

Machuga, Pfeiffer, and Verma (2002) examined the effectiveness of EVA and EPS in predicting future earnings. The results indicate that EVA contains more incremental information than EPS in predicting future earnings. Prakash et al. (2003) investigated the impact of adoption of EVA on the key financial ratios as a proxy of firm's performance. The results indicated that most of the financial ratios were significantly improved after the adoption of EVA. Worthington and West (2004) examined whether EVA is more associated with stock returns than traditional accounting measures such as earnings and net cash flow for 110 Australian companies over the period 1992-1998. Results indicated that EVA is more closely related to stock returns than traditional accounting measures.

Kim, Jae-Hyeon, and Yun (2004) investigated the significance of EVA, after controlling firm stage (contraction period vs. expansion...