VALUE BASED FINANCIAL PERFORMANCE MEASURES: AN EVALUATION OF RELATIVE AND INCREMENTAL INFORMATION CONTENT

VALUE BASED FINANCIAL PERFORMANCE MEASURES: AN EVALUATION OF RELATIVE AND INCREMENTAL INFORMATION CONTENT Pierre Erasmus Absrac Value-based (VB) financial performance measures are ofen advanced as improvemens over measures faciliaes he evaluaion of value creaion. Furhermore hey aemp o remove some accouning disorions resuling from he limiaions of convenional accouning informaion. This paper invesigaes he abiliy of four VB measures o explain marke-adjused share reurns and compare i o ha of some radiional measures. Empirical resuls indicae ha he relaive informaion conens of he VB measures are no greaer han ha of earnings. The incremenal informaion conen ess indicae ha heir componens add significanly o he informaion conen of earnings, bu ha he level of significance is relaively low. Keywords: financial performance, cos of capial, accouning informaion Deparmen of Business Managemen, Universiy of Sellenbosch, Privae Bag 1, Maieland, 7602, SOUTH AFRICA E-mail: pde@sun.ac.za, Tel : +27 21 8082215, Fax : +27 21 8082226 1. Inroducion Firms focused on he maximisaion of shareholder value need o ensure ha all aciviies yield posiive ne presen values. A number of value-based financial performance measures have been developed in an aemp o guide managemen acions owards achieving his objecive. These value-based measures, such as Economic Value Added (EVA) and Cash Value Added (CVA of capial and o adjus financial saemen informaion in order o remove some of he accouning disorions conained in radiional financial performance measures. Performance exceeding he cos of capial yields value, while he failure o achieve his resuls in he desrucion of shareholder value. Value-based financial performance measures (VBM) are presened by heir proponens as a major improvemen over he radiional performance measures. Mos imporanly, cos of capial in heir calculaion hey could be applied in order o evaluae he value creaing Lehn and Makhija, 1996: 35). If he reurns generaed xcess of he cos of capial, hese projecs would yield posiive ne presen values and consequenly shareholder value is increased (Gran, 2003: 81; Sewar, 1991: 174). These VBM also aemp o overcome some of he problems associaed wih he radiional measures by removing he accouning disorions conained in he financial saemens (Ehrbar, 1998: 80; Peerson and Peerson, 1996: 10; Sewar, 1991: 66). Perhaps one of he bes known value-based performance measures is Economic Value Added (EVA). EVA is an esimae of he economic profi generaed by a firm (Sewar, 1994: 73) and is afer ax (NOPAT) o he oal cos of all is forms of capial (deb, as well as equiy) (Gran, 2003: 2). Ma in shareholder value creaed (Sewar, 1991: 174). Proponens of he measure repor high levels of correlaion wih share reurns (Worhingon and Wes, Mi 117; Gran, 1996: 44; Lehn and Makhija, 1996: 36; Peerson and Peerson, 1996: 45; Sewar, 1994: 75, 136; Sewar, 1991: 66). The measure Cash Value Added (CVA) is considered as anoher form of residual income cash flow and a capial charge based on he gross 2001: 440). One of he major differences beween CVA and EVA is ha depreciaion and accruals are added back o NOPAT when calculaing he operaing cash flow values included in CVA (Marin and Pey, 2000: 128). Furhermore, accumulaed depreciaion is included wih he invesed capial amoun when he gross invesed capial is deermined (Marin and (2001: 429), he calculaion of CVA is less complex 66

han he calculaion of EVA since no accouning adjusmens are required. They also argue ha since depreciaion is added back during he calculaion of They perceive his characerisic of CVA as an advanage over EVA where differen depreciaion policies can resul in large variaions in he value of he measure. A number of limiaions wih regard o CVA, however, are also highlighed. According o Young measure han CVA. They argue ha he problem of differen depreciaion policies in he case of EVA can be solved by including an accouning adjusmen. Furhermore, hey indicae ha by removing accruals and depreciaion from he calculaion of CVA he measure may loose imporan informaion required by he marke when evaluaing an enerprise. The process of removing he effecs of accouning accruals in he calculaion of CVA could also be relaively complex. They also warn ha he incorporaion of CVA values ino valuaion models should be considered carefully since CVA is based on hisorical accouning figures ha do no represen he expeced fuure cash flow generaed by he enerprise (Young Anoher problem experienced wih CVA occurs when uneven cash flow values are considered (Marin and Pey, 2000: 149). The resuling CVA values may provide conflicing signals wih regard o he value creaion of he projecs under consideraion. From he exising lieraure i is no clear wheher CVA is able o ouperform oher financial performance measures. The measure Cash Flow Reurn on Invesmen (CFROI) has been presened as an improvemen over some of he oher radiional and value-based measures by is proponens (Dzamba, 2003: 10). I is calculaed by considering he inflaion-adjused invesmen in asses, he inflaion-adjused cash flow generaed by employing hese asses in he firm, and deermines he yield generaed over he esimaed lifeime of he asses. Madden (1999: 110) considers he calculaion of CFROI o be based on basic DCF principles. The four inpus required o calculae he measure are as follows: o The average life of he depreciaing asses. o The oal amoun of asses (includes boh depreciaing, as well as nondepreciaing asses) adjused for inflaion. o The inflaion-adjused cash flows generaed by he asses over heir o lifeime. The final inflaion-adjused residual value of he non-depreciaing asses a he end of he asse lifeime. The calculaions of he CFROI inpus are discussed in greaer de These four inpus are represened in he cash flow diagram provided in Figure 1: Inflaion-adjused gross cash flows Non-depreciaing asses Non-depreciaing asses 1 2 3 4 5 Esimaed asse lifeime Depreciaing asses Figure 1. Cash flow diagram represening he four CFROI componens 67

Based on hese inpus he fi calculaed as he discoun rae ha would ensure ha he presen value of all he fuure cash flows (he equal annual inflaion-adjused gross cash flows, as well as he erminal non-depreciaing asses amoun) is equal o he iniial invesmen (oal nondepreciaing and depreciaing asses). As such, he CFROI may be viewed as a reurn on invesmen (ROI). However, i is no calculaed for individual projecs, bu raher for he firm as a whole. This CFROI figure is compared o h inflaion-adjused (real) cos of capial. If a firm is able o generae CFROI values in excess of is inflaion-adjused cos of capial i should increase is real cos of capial will resul in he desrucion of measure is ha is focuses on he reurn offered o all he capial providers of he firm and no only he shareholders (Madden, 1999: 101). Relaively lile empirical research, however, have been conduced on he performance of CFROI relaive o oher financial performance measures. In his paper he abiliy of he value-based measures residual income (RI), EVA, CVA and CFROI o explain marke-adjused share reurns is invesigaed for a sample of firms lised in he Indusrial Secor of he Johannesburg Securiies Exchange (JSE) and compared o ha of he radiional financial performance measures earnings before exraordinary iems (EBEI) and operaing cash flow (CFO). In he firs par of he sudy he relaive informaion conens of he value-based measures relaive o he radiional measures are evaluaed. The second par of he sudy invesigaes he incremenal informaion conen of he componens of he valuebased measures, and es wheher he inclusion of hese componens conribues significanly o he informaion conen of he oher measures. The empirical resuls indicae ha he relaive informaion conens of he value-based measures are no greaer han ha of earnings. The incremenal informaion conen ess indicae ha he componens of some of he value-based measures do add significanly o he informaion conen of earnings. The level of significance, however, is relaively low. The remainder of he paper consiss of six secions. The firs secion focuses on he breakdown of he measures ino heir conribuing componens ha is required for he informaion conen ess. The second secion describes he research mehod. The hird secion conains he descripive saisics of he measures and componens included in he relaive and incremenal informaion conen ess. The fourh secion provides he resuls from he relaive informaion conen ess, while he fifh secion repors on he incremenal informaion conen ess. The final secion conains he summary and he conclusions. 2 Componens of he Value-Based Measures This paper invesigaes he relaive and incremenal informaion conen of he measures cash flow reurn on invesmen (CFROI), nominal and inflaionadjused cash value added (CVA nom and CVA real ), nominal and inflaion-adjused economic value added (EVA nom and EVA real ), operaing cash flow (CFO), earnings before exraordinary iems (EBEI) and residual income (RI). To do so, hese measures are pariioned ino heir conribuing componens using an approach applied by Biddle, Bowen and Wallace (1997: 305). The following secion provides a break-down of he componens included in he calculaion of he nominal versions of he measures included in he sudy. Thereafer, he inflaion adjusmens proposed by Inernaional Accouning Sandard 15 (IAS15) are highlighed. Finally, he componens of he inflaionadjused measures EVA real, CVA real and CFROI are considered. 2.1 Nominal Measures To explore he relaionships beween he various measures, one should commence by defining EBEI, and hen discuss all he addiional componens required o calculae he measures. According o Biddle e al. (1997: 305) a f defined as follows: EBEI = CFO + Accrual, EBEI = The earnings before exraordinary iems and ax for period. CFO = The ne cash from operaing aciviies. Accrual = The oal operaing accruals of he firm. The difference beween EBEI and he ne operaing profi afer ax (NOPAT) is ha NOPAT does no ake he afer-ax ineres expense ino accoun, while EBEI does. Therefore: NOPAT - ATIn = EBEI ATIn = Ineres expense afer provision for ax While EBEI makes provision for he cos of deb by subracing he ineres expense, RI is calculaed by deducing he cos of he oal (i.e. deb and equiy) capial. RI = NOPAT (c x IC -1 ) c = capial (WACC) afer ax IC -1 = The amoun of capial invesed in he firm a he beginning of he period Firms ha achieve posiive RI values are able o generae profis in excess of heir oal cos of capial, and consequenly shareholder value should be creaed. Negaive RI values are an indicaion ha insufficien profis are generaed, and as a resul, shareholder value could be desroyed. 68

EVA is calculaed in a similar way as RI. The major difference beween he wo measures relaes o a number of adjusmens o NOPAT and IC included in he calculaion of EVA. These adjusmens are included wih a view o removing some of he accouning disorions idenified by Sewar (1991: 28). EVA =(NOPAT + AccAdj op; ) [c x (IC -1 + AccAdj c; )] AccAdj op; =Adjusmens o remove he accouning disorions from operaing profi AccAdj c; =Adjusmens o remove he accouning disorions from invesed capial Since EVA values are no published by Sern Sewar for Souh African firms, he EVA values are obained from he McGregor BFA daabase (2005). Alhough hese EVA values do no include all he adjusmens recommended by Sern Sewar, he sandardisaion process applied o he financial saemens conained in he daabase already makes provision for a number of he adjusmens. operaing cash flow raher han operaing profi (as was he case for EVA), and subracing he gross capial charge. To conver NOPAT ino he operaing cash flow, depreciaion and amorisaion are added back (Marin & Pey, 2000: 128). Changes in oher long-erm liabiliies, such as provisions and deferred axes, are also added o NOPAT o conver i ino a capial charge is based on he gross value of he invesed capial and no on he ne figure (Marin & Pey, 2000: 141). Accumulaed depreciaion is, herefore, added back o he invesed capial. CVA =Operaing cash flow gross capial charge =(NOPAT + CVAAdj op; ) [c x (IC -1 + AccDepr -1 )] CVAAdj op; =Depreciaion, amorisaion and changes in oher long-erm liabiliies AccDepr -1 =Accumulaed depreciaion Based on hese definiions CVA can be presened as follows: CVA=CFO + Accrual + ATIn CapChg + AccAdj + CVAAdj CapChg =c x IC -1 AccAdj =AccAdj op; (c x AccAdj c; ) CVAAdj=CVAAdj op; AccAdj op; + [c x (AccAdj c; + AccDepr -1 )] 2.2 Inflaion-Adjused Measures In addiion o he nominal measures, his sudy also invesigaes he informaion conen of he inflaionadjused versions of EVA and CVA, as well as he measure CFROI. In order o calculae he inflaionadjused versions of hese measures, inflaion adjusmens are calculaed according o he guidelines conained in IAS15. These guidelines recommend adjusmens o he cos of sales, he depreciaion, he level of gearing, and he propery, plan and equipmen (PPE). The calculaions of hese adjusmens are described in more deail in Afer calculaing he IAS15 inflaion adjusmens, he inflaion-adjused version of he measure EVA is calculaed as follows: EVA real; =NOPAT real; (IC real;-1 x creal; ) = (NOPAT nom; - COSAdj DeprAdj ) [(IC nom;-1 + PPEAdj ) x c ] real; EVA real; =EVA in real erms, calculaed afer he inflaion adjusmens o NOPAT and IC, are included NOPAT real; =NOPAT afer including he cos of sales, depreciaion and gearing adjusmens c real; =he inflaion-adjused cos of capial IC real;-1 =he invesed capial afer including he PPE inflaion adjusmen The real CVA is hen calculaed as follows: CVA real; = (NOPAT nom; + CVAAdj op; - COSAdj DeprAdj ) [ c x (IC nom; -1 + PPEAdj real + AccDepr -1 )] CVA real; = CVA in real erms, calculaed afer he inflaion adjusmens o NOPAT and capial, are included CVAAdj op; = Depreciaion, amorisaion and changes in oher long-erm liabiliies AccDepr -1 = Accumulaed depreciaion The measure cash flow reurn on invesmen (CFROI) compares he inflaion-adjused cash flow generaed by a firm wih he inflaion-adjused cash 2001: 382). By including he esimaed lifeime of he value of is non-depreciable asses an inernal rae of reurn is calculaed. This CFROI figure is hen -adjused (real) cos of capial. In order o invesigae he relaive and incremenal informaion conen of he measure and o compare i wih he oher measures included in his sudy he CFROI margin is defined as he difference CFROI Margin =CFROI - c real The CFROI margin can be presened as follows: CFROI Margin = CFO + Accrual + ATIn CapChg + AccAdj + InflAdj + CVAAdj real + CFROIAdj Accrual = The oal operaing accruals of he firm ATIn = Ineres expense afer provision for ax CapChg = The capial charge based on he cos of capial and he invesed capial a he beginning of he financial year AccAdj = The accouning adjusmens o NOPAT and IC -1 o calculae EVA nom InflAdj = The IAS15 inflaion adjusmens included o calculae EVA real 69

CVAAdjreal = The adjusmens made o EVA real o calculae CVA real CFROIAdj = The difference beween CVA real and he Margin The relaionship beween he CFROI Margin componens is summarised in Figure 2 (Biddle e al., 1997: 307): CFROI Margin = CFO + Accrual + ATIn CapChg + AccAdj + InflAdj + CVAAdj real + CFROIAdj earnings (EBEI) operaing profis (NOPAT) residual income (RI) economic value added (EVA) real economic value added (EVA real ) real cash value added (CVA real ) cash flow reurn on invesmen margin (CFROI Margin ) Figure 2. Componens of he cash flow reurn on invesmen margin (CFROI Margin ) 3 Research Mehod 3.1 Hypoheses The informaion conen of a financial measure refers o he addiional informaion ha he marke deduces from is publicaion and incorporaes ino he expeced fuure financial performance of he firm. In order o evaluae he relaive and incremenal informaion conen of he radiional and he value based measures included in his sudy, an approach developed by Biddle e al. (1997: 307) is applied. According o his approach, relaive informaion conen comparisons should be used o compare differen measures, or when a choice beween he measures is required. Incremenal informaion conen is used o deermine wheher one componen of a measure provides addiional informaion over and above ha provided by anoher componen. To invesigae he relaive informaion conen of he measures, he following null hypohesis is formulaed (Biddle e al., 1997: 308): H REL : The informaion conen of measure 1 is equal o ha of 2 where 1 and 2 are pairwise combinaions of he measures under invesigaion. Rejecion of he null hypohesis indicaes a saisically significan difference in he informaion conen of he wo measures. 70

In order o invesigae he incremenal informaion conen of he componens of measure i, i is necessary o decompose i ino is conribuing componens: i = Y 1 + Y 2 + Y 3 Y n The following null hypohesis is hen formulaed (Biddle e al., 1997: 308): H INC : Componen Y 1 does no provide informaion conen beyond ha provided by he remaining componens Y 2 -Y n where Y 1 -Y n are he various componens of he measure i invesigaed. Pairwise comparisons of he componens are conduced o evaluae he incremenal informaion conen. Rejecion of he null hypohesis indicaes ha he inclusion of he componen under invesigaion will conribue significan addiional informaion conen. 3.2 Saisical Techniques In order o evaluae he informaion conen of he measures, he relaionships beween he measures and marke adjused share reurns are invesigaed. For his purpose, regression analyses wih he share reurn as dependen variable and he various measures as he independen variables are conduced. The saisical echnique employed in his sudy focuses on he forecas errors of he various measures (calculaed as he difference beween he acual and expeced values), which are sandardised o size. When assessing he informaion conen of a measure, he saisical significance of he slope coefficien b 1 from he following ordinary-leas squares regression is examined (Biddle e al., 1997: 308): D = b 0 + b 1 FE / MVE -1 + e (1) where D (he dependen variable) is a measure of reurn for ime period ; FE / MVE -1 is he unexpeced realisaion (or forecas error) of he measure (FE ), divided by he he financial year (MVE -1 ); while e is a random disurbance erm. The unexpeced realisaion of he measure for ime period is defined as he difference beween he observed value of he measure ( expeced value of he measure (E( )): FE = E( ) (2) formed according o a discree linear sochasic process in auoregressive form, E( ) may be defined as: E( ) = 1-1 + 2-2 + 3-3 (3) auoregressive parameers. Subsiuing Equaions (2) and (3) ino Equaion (1) yields: D = b 0 + b 1 [ 1-1 + 2-2 + 3-3 / MVE -1 + e = b / b ' ' ' ' 0 b1 / MVE b2 / MVE b3 2 / MVE... e ' 4 3 MVE (4) E E b ' b, and where E b ' 0 b0 b1, 1 1 ' i bi i 1 b for i > 1. Equaion (4) provides he relaionship beween abnormal reurns (D ), and he lagged measures of accouning performance () scaled by MVE. For he purpose of his sudy, Equaion (5) is limied o one lag: ' ' ' D = b0 b1 / MVE b2 / MVE e (5) 3.2.1 Tess for Relaive Informaion Conen The relaive informaion conens of he measures are assessed by means of a saisical es developed by Biddle, Seow and Siegel (1995: 9). The independen variables are included in individual regressions agains he dependen variable based on he following equaion: ' ' ' D = b0 b1 / MVE b2 / MVE e (6) where D is he marke-adjused reurn on a, is one of he measures invesigaed, and MVE is he marke value According o he es, pairwise comparisons of he adjused R 2 values from he individual regressions are conduced. Saisically significan differences beween wo adjused R 2 values resul in he rejecion of he null hypohesis H REL. This indicaes a saisically significan difference in he abiliy of he wo measures under invesigaion o explain he variaion in he dependen variable (Biddle e al., 1997: 310). 3.2.2 Tess for Incremenal Informaion Conen In order o evaluae he incremenal informaion conen of he componens of he measures invesigaed in his sudy, he following regression is conduced (Biddle e al., 1997: 311): D = d 0 + d 1 Y 1; / MVE -1 + d 2 Y 1;-1 / MVE -1 + d 3 Y 2; / MVE -1 + d 4 Y 2;-1 / MVE -1 + e (7) where Y 1 and Y 2 are wo differen componens of he measure under invesigaion. The individual regression coefficiens are assessed by means of - ess o invesigae he conribuion of he specific componen. F-ess are used o assess he following join null hypoheses: H : d 1 = d 2 = 0 0Y 1 H 0Y 2 : d 3 = d 4 = 0 Rejecion of he null hypoheses indicaes ha he inclusion of a componen provides significan incremenal informaion. 3.3 Measures 3.3.1 Dependen Variable The relaive and incremenal informaion conen ess applied in his sudy focus on he relaionship beween 71

he independen variables and he unexpeced reurn er o esimae he unexpeced reurn, he marke adjused reurn is calculaed (Biddle e al., 1997: 312). This value indicaes wheher a firm over- or under performed relaive o he overall marke. MkAdjRe The marke adjused reurn is calculaed as he difference beween he 12-monh compounded reurn on a share and he 12-monh compounded reurn on he ALSI index. These reurns are calculaed for a period ending hree monhs afer -end o ensure ha he informaion conained in he financial saemens is refleced in he share prices. The 12-monh compounded share reurns, as well as he reurn on he ALSI index, are obained from he McGregor BFA daabase (2005). 3.3.2 Independen Variables The primary objecive of his sudy is o invesigae he relaive and he incremenal informaion conen of a number of radiional and value based financial performance measures. The measures included in he relaive informaion conen es are CFO, EBEI, RI, EVA, and CVA, as well as he inflaion-adjused measures EVA real, CVA real and CFROI. The measures are calculaed based on informaion obained from he sandardised financial saemen daa conained in he McGregor BFA daabase (2005). Sern Sewar does no publish EVA values for Souh African firms. The McGregor BFA daabase (2005), however, conains EVA values ha are calculaed based on he sandardised financial saemens included in he daabase. Through he sandardisaion process applied by he daabase he majoriy of he EVA accouning adjusmens are addressed. The equiy adjusmens proposed by Sern Sewar, however, are no included in he EVA values repored in he daabase. In he case of firms lised a he end of he research period, values for EVA, cos of capial and invesed capial are obained from he McGregor BFA daabase (2005). Since hese values are no available for hose firms ha delised during he period under review, hey are esimaed using he same mehod as he one employed in he daabase. In order o evaluae he effec of inflaion on he measures, he inflaion adjusmens proposed by IAS15 are quanified and included in he calculaion of EVA real and CVA real. CFROI values are no available from he McGregor BFA daabase (2005). Consequenly, hese values are esimaed by using he approach described by Madden (1999). In order o evaluae he incremenal informaion conen of he componens of he measures EVA, EVA real, CVA, CVA real and CFROI, he componens indicaed in Figure 2 are required. These componens are quanified by informaion obained from he McGregor BFA daabase (2005). To reduce heeroscedasiciy in he daa, all he independen variables are divided by he marke value of equiy as measured hree monhs afer he -1 ) (Biddle e al., 1997: 313). This period is chosen o correspond wih he period over which he dependen variable is calculaed. 3.4 Daa The measures CFO, EBEI, RI, EVA nom, EVA real, CVA real and CFROI, as well as heir conribuing componens, are calculaed for all firms lised in he indusrial secor of he JSE during he 15-year period from 1991 o 2005. Those firms lised a he end of his period are considered for he iniial sample. Focusing only on hese firms, however, would expose he sudy o a survivorship bias. Consequenly, all delised firms ha were lised during he period under invesigaion are also included in he sample. A oal of 198 lised firms and 188 delised firms are idenified. Following Biddle e al. (1997: 311), hose observaions in excess of eigh sandard deviaions from he median are classified as exreme ouliers, and consequenly 41 observaions were removed from he sample. The number of observaions classified as exreme ouliers relaive o he overall sample is relaively small. A closer invesigaion of hose firms classified as exreme ouliers also reveals ha he majoriy of hese values are observed for firms a he end of heir lifecycle, where financial performance is diminishing, and share prices have already collapsed. Oher examples include he firs financial year of firms ha lised for he firs ime, or firms ha underwen financial reorganisaion. Boh he dependen and independen variables are also median. The final sample invesigaed in he informaion conen ess consiss of 316 firms wih 2 837 complee observaions. 4 Descripive Saisics of he Measures and Componens Included in he Informaion Conen Tess 4.1 Measures Included in he Relaive Informaion Conen Tess The descripive saisics of he winsorised values of MkAdjRe, EBEI, CFO, RI, EVA nom, EVA real, CVA real and CFROI Margin included in he relaive informaion conen ess pooled across ime are provided in Table 1. 72

Table 1. Descripive saisics on he dependen and independen variables in he relaive informaion conen ess of CFROI Margin Descripive saisics Dependen Variable Independen Variables MkAdjRe EBEI CFO RI EVA nom EVA real CVA real CFROI Margin Mean 0.141 0.202 0.297-0.089-0.142-0.135-0.039-0.007 Median 0.018 0.125 0.151 0.003-0.019-0.007 0.022-0.002 Sd. Dev. 0.761 0.508 0.647 0.495 0.532 0.687 0.698 0.155 Correlaions Dependen Variable Independen Variables MkAdjRe EBEI CFO RI EVA nom EVA real CVA real CFROI Margin MkAdjRe 1.000 EBEI 0.297 1.000 CFO 0.165 0.491 1.000 RI 0.161 0.374 0.018 1.000 EVA nom 0.118 0.261-0.037 0.909 1.000 EVA real 0.095 0.229-0.065 0.747 0.833 1.000 CVA real 0.121 0.314 0.069 0.687 0.748 0.954 1.000 CFROI Margin 0.186 0.280 0.056 0.418 0.342 0.323 0.317 1.000 Noes: m he median values. All he independen variables are size-adjused by divided hem by he marke value of he equiy as measured hree monhs afer he beginning of he financial year. All correlaions are significan a he 1% level, excep beween CFO, and RI and EVA nom. The measures EBEI and CFO exhibi he highes mean and median values, while he value based measures display small mean and median values, which are all close o zero. The lowes mean and median values are observed for he measure CFROI Margin. If he correlaions are considered, all are found o be saisically significan a he 1% level, excep he correlaions beween CFO, and RI and EVA nom. The highes correlaion beween he dependen variable and an independen variable is observed beween MkAdjRe and EBEI. In he case of CFROI Margin, he highes correlaion is beween he measure and RI (correlaion coefficien of 0.418). I is also ineresing o noe ha he correlaion beween MkAdjRe and CFROI Margin is he highes for all he value based measures. 4.2 Componens Included in he Incremenal Informaion Conen Tess The descripive daa of he winsorised CFROI Margin componens included in he incremenal informaion conen ess pooled across ime are provided in Table 2. The correlaions beween he majoriy of he CFROI Margin componens are saisically significan a he 1% level. The correlaion beween AccAdj and InflAdj is significan a he 5% level, while he correlaion beween CapChg and Accruals is significan a he 10% level. Only he correlaions beween MkAdjRe and InflAdj, AccAdj and Accruals, and CFROIAdj and ATIn are no significan. 5 Relaive Informaion Conen Tess of CFROI margin The relaive informaion conen of he measures included in his chaper is evaluaed by comparing he adjused R 2 values obained from seven separae regressions based on he following equaion: D = b 0 + b 1 / MVE -1 + b 2-1 / MVE -1 + e. (8) D = he marke-adjused reurn for period. = one of he seven measures CFO, EBEI, RI, EVA nom, EVA real, CVA real and CFROI Margin. 73

MVE -1 = he marke value of he equiy hree monhs afer he beginning of he financial year. The resuls from he relaive informaion conen ess are provided in Table 3: Table 2. Descripive saisics on he dependen and independen variables in he incremenal informaion conen ess of he CFROI Margin componens Dependen Variable MkAdjRe Descripive saisics Independen Variables CFO Accruals ATIn CapChg AccAdj InflAdj CVAAdj rea Mean 0.141 0.297-0.069 0.086 0.378-0.053 0.009 0.096 0.031 Median 0.018 0.151-0.022 0.029 0.169-0.017 0.008 0.038-0.017 Sd. Dev. 0.761 0.647 0.589 0.175 0.650 0.215 0.346 0.195 0.667 Dependen Variable MkAdjRe MkAdjRe 1.000 Correlaions Independen Variables CFO Accruals ATIn CapChg AccAdj InflAdj CFO 0.165 1.000 Accruals 0.054-0.505 1.000 ATIn 0.094 0.224-0.088 1.000 CapChg 0.139 0.441-0.035 0.622 1.000 AccAdj -0.068-0.117-0.008-0.263-0.228 1.000 InflAdj 0.004-0.078 0.052 0.208 0.051 0.040 1.000 CVAAdj real 0.112 0.446-0.089 0.561 0.518-0.181 0.264 1.000 l CVAAdj rea CFROIAdj -0.082-0.058-0.165 0.012 0.282-0.337-0.617-0.259 1.000 l CFROIAdj CFROIAdj Noes: deflaed by he marke value of he equiy as measured hree monhs afer he beginning of he financial year. Significan a he 1% level Significan a he 5% level Significan a he 10% level Panel A of Table 3 conains he adjused R 2 values calculaed for he seven separae regressions. The measures are arranged in decreasing order based on heir adjused R 2 values. EBEI has a significanly higher adjused R 2 value (0.0773) han he oher measures. The regression analysis based on he CFROI Margin values yields he second larges adjused R 2 value (0.0438). I is followed by RI (0.0375), CFO (0.0319), EVA nom (0.0305), EVA real (0.0139) and CVA real (0.0138) correspondingly. In erms of relaive informaion conen, EBEI appears o ouperform he oher measures. In erms of he value based financial measures, CFROI Margin yields he bes resuls. According o Hayn (1995: 127), Burgsahler and Dichev (1997: 192) and Collins, Pincus and ie (1997) profiable firms exhibi larger earnings responses han loss-making 51) also recommends a disincion beween posiive and negaive EVA values. The ess for relaive informaion conen are repeaed afer allowing differen coefficiens for he posiive and negaive values of he differen measures. The resuls from hese regressions are provided in Panel B of Table 3. All he measures exhibi higher adjused R 2 values. The measure RI experienced he larges increase in is adjused R 2 value (0.0375 o 0.1126), and i exhibis he highes adjused R 2 value overall when compared o he oher measures. I is followed by EBEI (0.0886), EVA nom (0.0855), EVA real (0.0635), CVA real (0.0597) and CFO (0.0472) respecively. 74

Table 3. Tess of he relaive informaion conen of CFROI Margin, CVA real, EVA real, EVA nom, residual income, earnings and operaing cash flow Relaive informaion conen Rank order of Observaio R 2 ns (1) (2) (3) (4) (5) (6) (7) Panel A: Coefficien of he posiive and negaive values of each performance measure consrained o be equal a All firms 2450 EBEI > CFROI Margi n > RI > CFO > EVA nom > EVA real > CVA real Adj. R 2 0.0773 0.0430 0.0375 0.0319 0.0305 0.0139 0.0138 Panel B: Coefficien of posiive and negaive values of each performance measure allowed o differ b All firms 2450 RI > EBEI > EVA no m > EVA real > CVA real > CFO > CFROI Margi Adj. R 2 0.1126 0.0886 0.0855 0.0635 0.0597 0.0472 0.0429 Noes: a In Panel A, he regression based on Equaion (8) is conduced, D = b 0 + b 1 / MVE -1 + b 2-1 / MVE -1 + e. D is he marke-adjused reurn for period, is one of he seven measures CFO, EBEI, RI, EVA nom, EVA real, CVA real and CFROI Margin, and MVE is he marke value of he equiy hree monhs afer he beginning of he financial year. b In Panel B, he regression used in Panel A is adjused o allow differen coefficiens for posiive and negaive values of he independen variable: The regression based on he following equaion is conduced, D = c 0 + c 1 ;pos / MVE - 1 + c 2 ;neg / MVE -1 + c 3-1;pos / MVE -1 + c 4-1;neg / MVE -1 + e. D is he marke-adjused reurn for period, is one of he seven measures CFO, EBEI, RI, EVA nom, EVA real, CVA real and CFROI Margin, and MVE is he marke value of he equiy hree monhs afer he beginning of he financial year. n In he case of CFROI Margin, however, he measure dropped from he second o he las posiion overall in erms of he ranking of he adjused R 2 values. I is also he only measure where he adjused R 2 value decreased when he disincion beween posiive and negaive values is allowed. A possible reason for his decrease could be he variable naure of he CFROI values. The cash flows included in he based on he changes in he profi figures, however, could resul in CFROI values swiching from a posiive o a negaive value (and vice versa). These changes are no he financial performance, bu raher he way in which CFROI values (and IRR measures in general) are calculaed. Disinguishing beween he posiive and negaive values of he measure herefore reduces he adjused R 2 value of he regression analysis. 6 Incremenal Informaion Conen Tess Of The CFROI margin Componens In order o evaluae he incremenal informaion conens of he CFROI Margin componens, he following regression analysis is conduced: MkAdjRe = d 0 + d 1 CFO / MVE -1 + d 2 CFO -1 / MVE -1 + d 3 Accrual / MVE -1 + d 4 Accrual -1 / MVE - 1 + d 5 ATIn / MVE -1 + d 6 ATIn -1 / MVE -1 + d 7 CapChg / MVE -1 + d 8 CapChg -1 / MVE -1 + d 9 AccAdj / MVE -1 + d 10 AccAdj -1 / MVE -1 + d 11 InflAdj / MVE -1 + d 12 InflAdj -1 / MVE -1 + d 13 CVAAdj real; / MVE -1 + d 14 CVAAdj real; -1 / MVE -1 + d 15 CFROIAdj / MVE -1 + d 16 CFROIAdj -1 / MVE -1 + (9) The resuls of he incremenal informaion conen ess of he CFROI Margin componens are provided in Table 4. If he resuls from he incremenal informaion conen ess are considered, i is observed ha he Margin componens excep InflAdj are highly significan. If he correlaion coefficien of ATIn -1 is significan. The F- saisic for he componen InflAdj is no saisically significan, indicaing ha i does no conribue significan informaion conen. The oher F-saisics, however, are all significan, indicaing ha he remaining CFROI componens conain saisically significan incremenal informaion conen. The adjused R 2 value for he muliple regression analysis conduced o evaluae he incremenal informaion conen of he CFROI Margin componens in his sudy, however, is much lower han he values obained in previous sudies invesigaing he measures EVA real, CVA nom and CVA real. An adjused R 2 value of 0.0628 is observed in he case of he CFROI Margin componens, compared o values of 0.1861, 0.1880 and 0.1995 (respecively) when he componens of he oher measures are invesigaed (Erasmus, 2008). Alhough he incremenal informaion conen of he CFROI Margin 75

componens are saisically significan, i explains less of he variaion in he marke adjused share reurns. Table 4. Tess of incremenal informaion conen of CFROI Margin componens: CFO, operaing accruals, afer-ax ineres, capial charge, accouning adjusmens, inflaion adjusmens, real cash value added adjusmens and CFROI adjusmens All firms a -sa F-sa p-value b Observaions 2450 Consan 0.060 3.35 CFO CFO -1 0.218-0.029 5.12-0.62 13.36 <0.0001 Accrual -1-0.048-1.14 Accrual 0.134 3.46 5.97 0.0026 ATIn -1 0.700 3.79 ATIn -0.442-2.43 7.26 0.0007 CapChg -1-0.101-1.49 CapChg 0.186 2.68 3.63 0.0265 AccAdj -1 0.011 0.12 AccAdj -0.302-3.25 5.51 0.0041 InflAdj -1 0.030 0.37 InflAdj -0.154-1.94 1.99 0.1364 CVAAdj -1 0.253 1.55 CVAAdj -0.471-3.02 4.82 0.0082 CFROIAdj -0.208-3.81 CFROIAdj -1 0.042 0.72 7.39 0.0006 Noes: a The regression based on he following equaion is conduced: MkAdjRe = d 0 + d 1 CFO / MVE -1 + d 2 CFO -1 / MVE -1 + d 3 Accrual / MVE -1 + d 4 Accrual -1 / MVE -1 + d 5 ATIn / MVE -1 + d 6 ATIn -1 / MVE -1 + d 7 CapChg / MVE -1 + d 8 CapChg -1 / MVE -1 + d 9 AccAdj / MVE -1 + d 10 AccAdj -1 / MVE -1 + d 11 InflAdj / MVE -1 + d 12 InflAdj -1 / MVE -1 + d 13 CVAAdj / MVE -1 + d 14 CVAAdj -1 / MVE -1 + d 15 CFROIAdj / MVE -1 + d 16 CFROIAdj -1 / MVE -1 + e. D is he marke-adjused reurn for period, while he independen variables are he CFROI Margin componens (CFO, accruals, afer-ax finance cos, capial charge, accouning adjusmens, inflaion adjusmens and cash value added adjusmens). MVE is he marke value of equiy hree monhs afer he sar of he financial year. b p-values in parenheses represen non-direcional F-es of he null hypohesis of no incremenal informaion conen (Hypohesis H INC ) Significan a he 1% level Significan a he 5% level Significan a he 10% level 7 Summary The value-based financial performance measures economic value added (EVA), cash value added (CVA) and cash flow reurn on invesmen (CFROI) are proposed by cerain research sudies as improvemens over he radiional financial measures. The objecive of his paper was o evaluae he relaive and incremenal informaion conen of hese value-based measures compared o ha of he radiional measures earnings and cash from operaions. When he relaive informaion conens of he differen value-based financial performance measures are invesigaed, he resuls indicae ha hey are no able o ouperform earnings (EBEI) in explaining marke adjused share reurns. The resuls from he incremenal informaion conen ess indicae ha he adjusmens required in order o calculae he various value-based measures do conribue saisically significan incremenal informaion conen. If he adjused R 2 values of he muliple regression analyses conduced o evaluae he incremenal informaion conen of he value-based measures are compared o he adjused R 2 values obained for he radiional measures, however, a much lower value is observed. The componens of he value-based measures herefore explain significanly less of he variaion in marke adjused share reurns han he componens of he oher measures. Alhough he conribuions of hese componens are saisically significan, hey are no economically significan when combined ino he various measures. Based on he resuls repored in his sudy i appears as if he value based measures are no able o ouperform he relaively simple radiional financial performance measure earnings (EBEI) in explaining he variaion in marke adjused share reurns. The incremenal informaion conen ess conduced o evaluae he conribuion of he componens of he value-based measures also yield much lower resuls han for similar ess conduced for he radiional measures. 76

References 1. Bacidore, J.M., Boquis, J.A., Milbourn, T.T., & Thakor, A.V. (1997). The search for he bes performance measure. Financial Analyss Journal, 53(3), 11-20. 2. Biddle, G.C., Bowen, R.M., & Wallace, J.S. (1999). Evidence on EVA. Journal of Applied Corporae Finance, 12(2), 69-79. 3. Biddle, G.C., Seow, G.S., & Siegel, A.F. (1995). Relaive versus incremenal informaion conen. Conemporary Accouning Research, 12(1), 1-23. 4. Burgsahler, D., & Dichev, I. (1997). Earnings, adapaion and equiy value. The Accouning Review, 72(2), 187-215. 5. Collins, D., Pincus, M., & ie, H. (1997). Equiy valuaion and negaive earnings: The role of book value of equiy. Unpublished paper, Universiy of Iowa, Iowa Ciy, IA. 6. Dzamba, A. (2003). Focus on CFROI analysis o Financial Analysis, Planning & Reporing, 3(11), 10-12. 7. Ehrbar, A. (1998). EVA: The real key o creaing wealh. New York: John Wiley & Sons. 8. Erasmus, P.D. (2008). The relaive and incremenal informaion conen of he value based financial performance measure cash value added (CVA). Managemen Dynamics, 17(2), (Forhcoming). 9. Fabozzi, F.J., & Gran, J.L. (ed.). (2000). Valuebased merics: Foundaions and pracice. New Hope: Frank J. Fabozzi Associaes. 10. Gran, J.L. (2003). Foundaions of economic value added (2 nd ed.). Hoboken, New Jersey: John Wiley and Sons. 11. Gran, J.L. (1996). Foundaions of EVA TM for invesmen managers. Journal of Porfolio Managemen, 23(1), 41-48. 12. Hayn, C. (1995). The informaion conen of losses. Journal of Accouning and Economics, 20(2), 125-153. 13. Lehn, K.L., & Makhija, A.K. (1996). EVA and MVA as performance measures and signals for sraegic change. Sraegy and Leadership, 24(3), 34-40. 14. McGregor BFA (Py.) Ld. (2005). McGregor BFA Version 04.211. 15. Madden, B.J. (1998). The CFROI valuaion model. Journal of Invesing, 17(1), 31-43. 16. Madden, B.J. (1999). CFROI valuaion: A oal sysem approach o valuing he firm. Boson: Buerworh-Heinemann. 17. Marin, J.D., & Pey, J.W. (2000). Value based managemen: The corporae response o he shareholder revoluion. Boson: Harvard Business School Press. 18. Journal of Applied Corporae Finance, 12(2), 92-96. 19. and marke value. Journal of Applied Corporae Finance, 9(1), 116-125. 20. Peerson, P.P., & Peerson, D.R. (1996). Company performance and measures of value added. Charloesville: The Research Foundaion of The Insiue of Charered Financial Analyss. 21. Sewar, G.B. (1994). EVA TM : Fac and fanasy. Journal of Applied Corporae Finance, 7(2), 71-84. 22. Sewar, G.B. (1991). The Ques for value: The EVA TM managemen guide. New York: HarperBusiness. 23. Worhingon, A.C., & Wes, T. (2004). Ausralian evidence considering he informaion conen of economic value added. Ausralian Journal of Managemen, 29(2), 201-223. 24. EVA and value-based managemen: A pracical guide o implemenaion. New York: McGraw Hill. 77