Strategy & Leadership

EVA & MVA as performance measures and signals for strategic change
Kenneth Lehn Anil K. Makhija
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Kenneth Lehn Anil K. Makhija, (1996),"EVA & MVA as performance measures and signals for strategic change", Strategy &
Leadership, Vol. 24 Iss 3 pp. 34 - 38
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 by Kenneth Lehn and Anil K. Makhija
Kenneth Lehn is Professor of Business Administration and Director of the Centerfor Research on Contracts
and the Structure of Enterprise in the Katz Graduate School of Business Administration at the University of
Pittsburgh. Anil Makhija is Associate Professor of Business Administration in the Katz Graduate School of
Business Administration at the University of Pittsburgh.

EV
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as PerformanceMeasuresand Signals for Strategic Change

T he increasing frequency with which the business
environment demands strategic change elevates the
role played by performance measures in assessing
alternative business strategies. Traditional accounting
measures of performance have long been criticized for
their inadequacy in guiding strategic decisions. Two
To shed empirical light on the subject, we have inves­
tigated the effectiveness of EVA and MVA as measures
of performance, as signals of strategic change, and as
metrics relevant to strategic development. T h e study
followed 241 firms over the period of 1987 to 1993. We
analyzed the relation between various performance mea­
alternative measures of business performance, EVA (eco­ sures and stock returns, which generally are considered
nomic value added) and MVA (market value added) to be the best benchmark for a firm's performance; the
have been attracting much attention of late. According to turnover of chief executives, which is an indicator of
a recent article in Fortune, EVA is employed by a large strategic change; and the desirable extent of diversifica­
number of firms, including Coca-Cola, AT&T, Quaker tion to be pursued by firms, which has been the subject
Oats, Eli Lilly, Georgia Pacific, and Tenneco.1 Unlike of considerable debate.
traditional accounting measures of performance, EVA EVA and MVA Defined
attempts to measure the value that firms create or EVA and related measures attempt to improve on tradi­
destroy by subtracting a capital charge from the returns tional accounting measures of performance by measuring
they generate on invested capital. In addition to their the economic profits of an enterprise—after-tax operat­
use as performance measures, EVA and MVA are recom­ ing profits less the cost of the capital employed to pro­
mended by some as metrics for executive compensation duce those profits. Details on how to estimate the para­
plans and the development of corporate strategies. meters necessary for the computation of economic prof­
Despite this wide interest in EVA and MVA, little is its are contained in the books of Stewart, Copeland et
known empirically about the advantages of these mea­ al., and Rappaport.2,3,4 Some of the ways in which EVA
sures over traditional accounting measures. Concep­ can be raised include increasing operating profits with­
tually, EVA and MVA are superior to accounting profits out new capital, lowering the cost of capital, increasing
as measures of value creation because they recognize the investments in projects that generate rates of return
cost of capital and, hence, the riskiness of a firm's opera­ greater than their cost of capital, and curtailing invest­
tions. However, conceptual superiority does not always ments in projects that generate rates of return less than
translate into practical advantage.

Strategy & Leadership May/june 1996

34
 "Collectively, the results [of the study] suggest that
EVA and MVA are effective performance measures that contain
information about the quality of strategic decisions and
serve as signals of strategic change. "
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their cost of capital. have become targets of hostile

EVA is closely related to takeovers that ultimately result­
MVA—the difference ed in the dismissal of chief execu­
between the market value of a tives and their management teams.
firm and the economic value of In the past several years, large insti­
the capital it employs. MVA effec­ tutional investors such as Calpers and
tively measures the stock market's esti­ TIAA-CREF have become more active in
mate of the net present value of a firm's challenging management teams that fail to cre­
past and expected capital investment projects. ate value; in many cases their activism has also
Theoretically, a firm's MVA at a given point in time is resulted in the dismissal of senior executives.
equal to the discounted present value of the yearly EVA In their quest for value, managers increasingly have
it is expected to generate. Hence, the theoretical under­ recognized the limitations of traditional accounting mea­
pinnings of both EVA and MVA are found in the net pre­ sures of performance such as return on assets (ROA),
sent value concept used by most firms in their capital return on equity (ROE), and return on sales (ROS).
budgeting decisions. Although useful for other purposes, these measures suf­
The increased interest in EVA, MVA, and related per­ fer from a major limitation as a measure of value cre­
formance measures reflects a heightened awareness by ation, because they ignore the cost of capital investments
corporate managers that their task is to create value for required to generate earnings. The sidebar describing an
shareholders. Corporate managers have had a legal duty analysis of XYZ Company demonstrates the limitations
to maximize shareholder value since the advent of the of ROA in measuring value added. (See page 36.)
corporate form in the 1800s. In recent years, various mar­ Stern Stewart & Co. coined the terms "EVA" and
ket mechanisms have evolved to discipline managers "MVA" and owns a trademark on both terms. In The
who stray from this goal in favor of other goals such as Questfor Value, Stewart discusses the theory underlying
maximization of size, earnings, earnings growth, earnings EVA and MVA, and he describes how to estimate these
per share, and market share. Since the early 1980s, two measures empirically. Although the terms EVA and
dozens of seemingly profitable Fortune 500 companies MVA are unique to Stern Stewart, others use different

Strategy & Leadership May/June 1996

35
 names for basically the same concept. For example,
XYZ Company: An Example Copeland, Koller, and Murrin refer to the "economic
XYZ is a telecommunications firm with two units—a local telephone profit model," while Rappaport refers to "shareholder
exchange network and a cellular unit, each accounting for 50 percent of value creation."
the firm's operations. The local telephone unit generates ROA of 8 per- Measuring Performance and Predicting CEO Firings
cent, and the cellular unit generates ROA of 10 percent; therefore, the Despite the wide interest in EVA and MVA,
firm as a whole generates an ROA of 9 percent. Without accounting for little evidence exists on the efficacy of using
the opportunity cost of the capital that investors have provided to the
these measures versus more traditional
accounting measures to evaluate firm per­
firm, it is impossible to determine if an ROA of 9 percent for this firm
formance. To test the validity of using
creates value. these new measures, we asked two simple
The local telephone unit is less risky than the cellular unit, and questions:
investors, therefore, require a lower return on capital invested in the ♦ How do EVA and MVA relate with stock perfor­
telephone unit than they do on invested capital in the cellular unit. The mance—a well established market measure of perfor­
required returns (i.e., the cost of capital) for the local telephone and
mance?
♦ In terms of an internal effect of performance, are
cellular units are 6 percent and 12 percent, respectively. Therefore, the
CEO firings related to EVA and MVA?
return that investors require on the company as a whole (i.e., the com- We collected data on EVA and MVA that Stern
pany's cost of capital) is 9 percent. With an ROA of 9 percent, the com- Stewart & Co. has published in various sources for 241
pany is neither creating nor destroying value. It is simply providing large U.S. companies for four years: 1987, 1988, 1992,
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investors with a return that they could have achieved by investing in and 1993. Although we would have liked to have found
other assets with equivalent risk. EVA and MVA data for the intervening years, we do not
believe our analysis is seriously impaired by these data
Local Telephone Unit Cellular Unit XYZ Company limitations. Roughly two-thirds of the sample consists of
Percent of Operations 50% 50% 100% firms in manufacturing industries.
Return on Assets 8% 10% 9%
For each firm, we computed six performance mea­
sures for each of the four years: three accounting rates of
Cost of Capital 6% 12% 9%
return (ROA, ROE, and ROS); stock returns; and EVA
Value Added +2% •2% 0 and MVA, both expressed as returns on equity value.
The limitations of using ROA and other accounting measures of
Using the relation of a measure with the stock returns as
a test of the effectiveness of the measure, we found that
performance to evaluate the performance of different units within a firm
all six measures are positively correlated with stock
also can be illustrated with this example. Looking only at ROA, it returns. This suggests that EVA and MVA, like the tradi­
appears that the cellular unit is outperforming the local telephone unit tional measures, are effective measures of performance.
by two percentage points. However, the ROA of the local telephone unit Moreover, even though not by a large difference, the
exceeds its cost of capital by two percentage points, while the ROA of correlation of EVA with stock returns is higher than the
the cellular unit falls short of its cost of capital by two percentage correlation of any of the other five measures with stock
returns, providing the EVA with a slight edge as a perfor­
points. Hence, the local telephone unit is creating value while the cellu-
mance measure.
lar unit is destroying value, even though the telephone unit has a lower Our next step was to study the consequences of cor­
ROA. porate performance, as measured in terms of EVA and
In this example, we have ignored the fact that, in practice, ROA—as MVA, for chief executives. We began with a search of
an accounting artifact—may hot measure economic returns. Permitted the business press and other sources to determine
accounting choices compound the problem, making the ROA incompa-
whether any of the firms' chief executive officers had
been fired during the period 1988-1995. If chief execu­
rable with even the appropriate cost of capital number.
tives left for reasons other than health, death, normal
retirement age, or another job opportunity, we assumed
they were dismissed for reasons related to performance.
We refer to these as cases of "CEO turnover."
We detected 34 cases of CEO turnover, including the
highly publicized dismissals of Robert Stempel at
General Motors, Kay Whitmore at Eastman Kodak, John
Akers at IBM, and Paul Lego at Westinghouse. The fre-

Strategy & Leadership May/June 1996

36
 "The marketfor chief executives acts as if it uses MVA, EVA, and stock returns
more than traditional accounting measures to judge chief executive performance.
Failure to perform in terms of EVA and MVA appears to have
serious consequences for top management."

quency of CEO turnover increased over above the median and 19.3 percent for
time, with two cases in 1988, three in firms with EVA below the median. The
1989, three in 1990, five in 1991, five evidence strongly suggests that chief
in 1992, seven in 1993, seven in executives who produce high MVAs
1994, and two in 1995. The inci­ and EVAs face significantly lower
dence of CEO turnover during rates of dismissal than their coun­
the period is about 14 percent. terparts who produce low MVAs
To determine whether the and EVAs.
incidence of CEO turnover is Not surprisingly, stock returns
related to a given performance are also highly correlated with
measure, we first ranked the CEO turnover. The CEO
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entire sample of 241 firms by turnover rate is 9.6 percent for

their average level of performance firms with stock returns above the
over the four years for which data median and 19.0 percent for firms
were available. We divided the sam­ with stock returns below the median.
ple into two subsamples consisting of This suggests that stock price perfor­
firms with performance above and mance is a significant determinant of
below the median level of performance. CEO turnover.
The incidence of CEO turnover was then The accounting measures generally are
compared across the two subsamples. If a given less correlated with CEO turnover. Neither ROA
performance measure is used by the market to assess nor ROE is significantly associated with CEO turnover,
managerial performance, the incidence of CEO turnover suggesting that managers are better served to focus on
should be significantly higher for firms with lower levels stock returns, EVA, and MVA. The incidence of CEO
of the performance measure. turnover is, however, more highly associated with ROS,
Exhibit 1 contains the findings of our analysis. The but the data do not permit much confidence in this
incidence of CEO turnover is significantly related to finding.
both MVA and EVA. The CEO turnover rate is 8.3 per­ These results support the arguments made by propo­
cent for firms with above median MVA and 20.0 percent nents of EVA and MVA. The market for chief executives
for firms with below median MVA. That is, chief execu­ acts as if it uses MVA, EVA, and stock returns more than
tives with below median MVA performance are fired traditional accounting measures to judge chief executive
roughly two-and-a-half times more frequently than chief performance. Failure to perform in terms of EVA and
executives with above median performance. Similarly, MVA appears to have serious consequences for top man­
the CEO turnover rate is 9.0 percent for firms with EVA agement. Because the dismissals of chief executives usu­
ally are associated with strategic change, EVA and MVA
appear to provide a signal of these changes as well.
The Relationship between EVA,
MVA, and Corporate Focus
To examine the effect of focus on corporate success, we
evaluated firms in terms of their performance on the six
measures and then compared them in relation to one
specific strategy—the decision to concentrate activities
in one core business rather than to form conglomerates

Strategy & Leadership May/June 1996

37
 in EVA terms is also better for the more narrowly
focused firms, although the data do not permit us to
draw that conclusion with reasonable confidence. These
results are similar to those found by Stern Stewart, as
reported by Judith Dobrzynski in her New York Times
article, "Why the Market Likes Johnny One-Notes and
Is Skeptical of One-Man Bands."5
The accounting measures also show that the perfor­
mance of more highly focused firms is significantly bet­
ter in terms of average ROA (12.74 percent for more
focused firms versus 9.97 percent for less focused firms),
but not in terms of individual ROE and ROS.
Conclusion
Although EVA and MVA have received con­
in the hope of exploiting economies of scale through size siderable attention in recent years and are
and synergy across businesses, that is, the extent to used by many prominent U.S. firms, there
which the activities of firms are focused or diversified. has been limited empirical study of these
To measure corporate focus, we used a revenue-based performance measures. For our sample of
Herfindahl index, which is equal to the sum of the 241 firms during the period 1987-1993, we
squared percentage of a firm's revenues derived from find that EVA and MVA are significantly posi­
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different lines of business. For firms in only one line of tively correlated with stock price performance, attesting
business, the Herfindahl measure takes the value of one. to their effectiveness as performance measures.
For firms in more than one line of business, the Furthermore, affirming the importance attached to these
Herfindahl takes on a value of greater than zero and less measures, we found an inverse relation between perfor­
than one; the more diversified a firm, the lower its mance in terms of EVA and MVA and CEO turnover.
Herfindahl. For each firm in the sample, we computed Finally, we found that firms with greater focus in their
its Herfindahl in each year and then found the four-year business activities have significantly higher MVA than
average. We ranked the sample by the average their less focused counterparts. Collectively, the results
Herfindahl, and categorized firms as having a focus that suggest that EVA and MVA are effective performance
was above or below the median. measures that contain information about the quality of
We found considerable variation in the focus of firms strategic decisions and serve as signals of strategic
in the sample. The least focused firms are General change.
Electric (Herfindahl of 0.113), followed by Tenneco
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Strategy & Leadership May/June 1996

38
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