Evaluating value based financial performance measures
Date
2008-03
Authors
Journal Title
Journal ISSN
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Publisher
Stellenbosch : University of Stellenbosch
Abstract
The primary financial objective of a firm is the maximisation of its shareholders’
value. A problem faced by the shareholders of a firm is that it is difficult to determine
the effect of management decisions on the future share returns of the firm.
Furthermore, it may be necessary to implement certain monitoring costs to ensure that
management is focused on achieving this objective. A firm would, therefore, benefit
from being able to identify those financial performance measures that are able to link
the financial performance of the firm to its share returns. Implementing such a
financial performance measure in the valuation and reward systems of a firm should
ensure that management is aligned with the objective of shareholder value
maximisation, and rewarded for achieving it.
A large number of traditional financial performance measures have been developed.
These measures are often criticised for excluding a firm’s cost of capital, and are
considered inappropriate to be used when evaluating value creation. Furthermore, it
is argued that these measures are based on accounting information, which could be
distorted by Generally Accepted Accounting Practice (GAAP). Studies investigating
the relationship between these measures and share returns also provide conflicting
results. As a result of the perceived limitations of traditional measures, value based
financial performance measures were developed. The major difference between the
traditional and value based measures is that the value based measures include a firm’s
cost of capital in their calculation. They also attempt to remove some of the
accounting distortions resulting from GAAP.
Proponents of the value based measures present these measures as a major
improvement over the traditional financial performance measures and report high
levels of correlation between the measures and share returns. A number of studies
containing contradictory results have been published. On the basis of these
conflicting results it is not clear whether the value based measures are able to
outperform the traditional financial performance measures in explaining share returns.
The primary objectives of this study are thus to:
• Determine the relationship between the traditional measures earnings before
extraordinary items (EBEI) and cash from operations (CFO), and shareholder
value creation;
• Investigate the value based measures residual income (RI), economic value added
(EVA), cash value added (CVA) and cash flow return on investments (CFROI),
and to determine their relationship with the creation of shareholder value;
• Evaluate the incremental information content of the value based measures above
the traditional measures. The information content of the traditional measures and the value based measures are
evaluated by employing an approach developed by Biddle, Bowen and Wallace
(1997). The first phase of this approach entails the evaluation of the relative
information content of the various measures in order to determine which measure
explains the largest portion of a firm’s market-adjusted share returns. The second
phase consists of an evaluation of the incremental information content of the
components of a measure in order to determine whether the inclusion of an additional
component contributes statistically significant additional information beyond that
contained in the other components. The study is conducted for South African
industrial firms listed on the Johannesburg Securities Exchange for the period 1991 to
2005.
The data required to calculate the measures investigated in the study are obtained
from the McGregor BFA database. This database contains annual standardised
financial statements for listed and delisted South African firms. It also contains EVA,
cost of capital and invested capital amounts for those firms listed at the end of the
research period. Including only these listed firms in the research sample would
expose the study to a survivorship bias. Hence these values are estimated for those
firms that delisted during the period under review by employing a similar approach to
the one used in the database. The resulting sample consists of 364 firms providing
3181 complete observations. Since different information is required to calculate the
various measures included in the study, different samples are compiled from this
initial sample and included in the tests conducted to evaluate the information content
of the measures.
The results of this study indicate that the value based measures are not able to
outperform EBEI in the majority of the relative information content tests.
Furthermore, the measures EVA, CVA and CFROI are also not able to outperform the
relatively simple value based measure RI. The results from the incremental
information content tests indicate that although some of the components of the value
based measures provide statistically significant incremental information content, the
level of significance for these relatively complex adjustments is generally low.
Based on these results, the claims made by the proponents of the value based
measures cannot be supported. Furthermore, if a firm intends to incorporate its cost
of capital in its financial performance measures, the measure RI provides most of the
benefits contained in the other more complex value based measures.
Description
Thesis (PhD (Economics))--University of Stellenbosch, 2008.
Keywords
Value based, Performance measures, Information content, Financial, Theses -- Economics, Dissertations -- Economics