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How does EVA promote shareholder interests? First, it clearly specifies to management that the primary financial objective of the company is to create shareholder wealth. Secondly, it emphasizes continuous improvement in the company's EVA as the basis for increased shareholder wealth. Assuming the efficient market hypothesis holds, stock price reflects the company's current performance; therefore, the level of EVA isn't important, but changes in that level are. Management focus on these two issues can result in dramatically increasing EVA.
Our methodology for studying the relationship between EVA and stock return consists of testing companies that are found in well known stock indices such as Standard & Poor's 500 (S&P 500) and the Dow Jones Industrial Average (DJIA).
1. INTRODUCTION
Economic Value Added (EVA) has become all the rage in the investing world. Stern Stewart has gone so far as to trademark the concept, though many academics challenge it as a knock-off of residual income. Stern Stewart has, however, been very successful touting the measure as the best measure of business performance and management discipline. Fortune Magazine annually publishes a list of top companies complete with and EVA numbers and rankings, crediting the measures for the creation (or destruction) of shareholder wealth. The Journal of Applied Corporate Finance annually publishes the EVA for the Stern Stewart Performance 1000, citing EVA as "the critical driver of a company's stock performance". Successful corporations are increasingly turning to EVA to measure performance. General Electric, AT&T, Chrysler, and Compaq use EVA for financial analysis. Coca Cola's late CEO, Roberto Goizueta, acknowledged the value of EVA and declared "You only get richer if you invest money at a higher rate than the cost of the money to you" (Fisher, 1995). In turn, investors and analysts are now scrutinizing company EVA just as they have historically observed EPS and PE ratios. Academic articles relating EVA success stories and promoting adoption of the measure abound (Blair, 1996; Byrne, 1994; Carr, 1996; Copeland and Meenan, 1994; Gressle, 1996; Tully 1993; Stern 1990; Rice, 1996; Pallerito, 1997; Martin, 1996).
As described by Stern Stewart, EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. In effect, it estimates the economic profit (or loss)...