Corporate Performance Measures in India: An Empirical Analysis WP-2007/01/A

Corporate Performance Measures in India:

An Empirical Analysis
Lokanandha Reddy Irala1

Abstract
Traditionally periodic corporate performance is most often measured using some
variant of historical accounting income (eg. Net Profit, EPS) or some measures
based on the accounting income (eg. ROI / ROCE). However it had long been
recognized that accounting income is not a consistent predictor of firm value
creation and the traditional measures are not appropriate for evaluation of
corporate performance

An appropriate measure of corporate performance on one hand should be highly

correlated to share holder return and on the other hand should be able to signal
the extent of periodic wealth creation. A search for such a measure had been the
trigger for the rapidly growing literature on value based management (VBM).
Among the set of popular VBM systems, a variant of the traditional residual
income measure known as Economic Value Added (EVA) is arguably the most
prominent

This paper examines whether Economic Value Added has got a better predictive
power relative to the traditional accounting measures such as EPS, ROCE,
RONW, Capital Productivity (Kp) and Labor Productivity (Lp)

Analysis of 1000 companies across 6 years (6000 company years), very much
supports the claim that the EVA is the better predictor of market value compared
to other accounting measures. EVA is gaining recognition as fundamental
measure of company performance despite the fact that it has been in existence
for a relatively short period of time.

Key Words: EVA, Performance Measures, Market Value

JEL Classification: G00, J33, L21, M40, M52

1. Introduction

For long, there had been wide acceptance on the objective of the firm -to maximize the value.

While the principle that the fundamental objective of the business-corporation is to increase the
value of its shareholders' investment is widely accepted, there is substantially less agreement about
how this is accomplished (Rappaport, 1986)

As the lenders (debt holders & others), can protect themselves contractually, the objective can be
narrowed down to maximizing stockholder value or stockholder wealth. When financial markets are

1
Associate Professor & Director-Administration, Dhruva College of Management, Hyderabad.
He can be reached at reddyirala@gmail.com

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Corporate Performance Measures in India: An empirical Analysis WP-2007/01/A

efficient, the objective of maximizing stockholder wealth can be narrowed even further- to
maximizing stock prices. (Damodaran, 2002)

Even though stock price maximization as an objective is the narrowest of the value maximization
objectives, it is the most prevalent one. It is argued that the stock prices are the most observable of
all measures that can be used to judge the performance of a publicly traded firm. Besides this, the
stock price is a real measure of stockholder wealth, since stockholders can sell their stock and
receive the price now.

Should we accept that the stock price maximization leads to firm value maximization, can we make
managers responsible for the stock price maximization? While the responsibility of firm value
maximization has to be fixed with the managers, using stock prices as a measure of periodic
measure of corporate performance throws a serious problem.

While many argue that the stock prices are not under the full control of the managers, there are
many others who believe that stock price maximization leads to a short term focus for manager-as
the stock prices are determined by traders, short term investors and analysts, all of whom hold the
stock for short periods and spend their time trying to forecast next quarter's earnings

So, traditionally periodic corporate performance is most often measured using some variant of
historical accounting income (eg. Net Profit, EPS) or some measures based on the accounting
income (eg. ROI / ROCE).

However it had long been recognized that accounting income is not a consistent predictor of firm
value creation and the traditional measures are not appropriate for evaluation of corporate
performance

An appropriate measure of corporate performance on one hand should be highly correlated to

share holder return and on the other hand should be able to signal the extent of periodic wealth
creation. A search for such a measure had been the trigger for the rapidly growing literature on
value based management (VBM). Among the set of popular VBM systems, a variant of the
traditional residual income measure known as Economic Value Added (EVA) is arguably the most
prominent

This paper examines whether Economic Value Added has got a better predictive power relative to
the traditional accounting measures such as EPS, ROCE, RONW, FCF, Capital Productivity (Kp)
and labor Productivity (Lp)

2. Traditional Performance Measures: A Critical Evaluation

It is known that the managers maximize firm value by accepting positive NPV investments-
Investments that earn more return than the hurdle rate (cost of capital).

2-1. Profits
Tying compensation to profits has obvious problems. An ambitious manager, expecting a quick
career jump might be tempted to earn more short-term profit- by cutting or postponing expenses on
Research & Development, maintenance, staff training etc –ignoring their long term consequences.

This apart, profit is an absolute measure of performance as it considers neither the cost nor the size
of capital employed to generate the given profit. So two companies can never be directly compared
based on their profits and hence the performance of their managers

Growth in profits does not necessarily mean that shareholders are better off. Any investment with a
positive rate of return (even 2 or 3 percent) will eventually increase earnings. If managers are told
to maximize growth in profits, they might purposefully invest in projects offering 2 or 3 percent rates
of return – projects that destroy value.

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Corporate Performance Measures in India: An Empirical Analysis WP-2007/01/A

Shareholders don’t want growth in profits for its own sake, and they are not content with 2 or 3
percent returns. They want positive NPV investments – they want the company to invest only if the
expected rate of return exceeds the cost of capital (hurdle rate). In some cases the incremental
profits may result from an un economically large increase in investment generating a return that is
not adequate even to cover the cost of capital.

2-2. Earnings per Share (EPS)

EPS is a measurement of company’s per share performance. It is a ratio of net income to the
number of shares out standing.

EPS -when compared to profits - is a relative measure as it considers the size of the capital (in the
form of numbers of share holders). However like profits it doesn’t consider the cost of capital
invested to generate the profits.

EPS as a performance measure might motivate the managers to resort to investment as long as
they generate positive returns – no matter they are much below the hurdle rate.

2-3. Return on Capital Employed (ROCE)

ROCE is the ratio of net operating profit to the net operating assets or capital.

ROCE is an improvement over EPS as it links the returns generated to the capital employed.
However it does not include the cost of such capital employed. For example two investments can’t
be rated as equally good even if they have the same ROCE unless costs of financing these
investments are equal

As a managerial performance measure, ROCE might encourage managers to reject even good
investments (whose expected returns exceed WACC) when such returns are expected to lower the
current Average ROCE.

2-4. Return on Equity (ROE) / Return on Net Worth (RONW)

ROE indicates how much the firm has earned on the funds employed by the shareholders.

ROE like ROCE doesn’t include cost of capital (Equity in this case) in its computation. ROE as a
performance measure might encourage managers to accept investments capable of adding some
earnings even if they don’t cover the cost of capital / earn the required return.

Besides this, ROE is very strongly affected by capital structure changes and hence might not
indicate the operating efficiency of managers

3. Economic Value Added

3-1. What is EVA?
Economic value added (EVA) provides the rupee value created for investors in a given time period
by weighing the profit generated by a decision against the value (cost) of the capital employed to
generate that profit.

EVA is the Adjusted Net Operating Tax After Tax (ANOPAT) for a period minus the capital charge
(the rupee cost of capital) of the investment over that period.

EVA can be expressed as

EVA = Adjusted Net Operating Profit After Taxes (ANOPAT) - Capital Cost

Where

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ANOPAT2 = Capital Employed (CE) X ROCE (as ROCE = EBIT (1-T) / CE)

Capital Cost = WACC X Capital Employed (CE)

Thus
EVA = Capital Employed (CE) X ROCE - WACC X Capital Employed

EVA = (ROCE - WACC) Capital Employed

Capital is generally measured by book value. WACC is the weighted Average of cost of Equity
(generally measured by CAPM) and cost of Debt.

3-2. EVA and Corporate Performance

If managers are told that the corporate performance is measured by EVA and their compensation is
liked to that, they would try to improve EVA by doing one or more of the following.

A. Improve returns with the existing Capital

Look at the EVA equation. EVA improves if managers earn more returns without
increasing the capital and its cost.

B. Employ Capital productively

EVA also improves when they employ less capital to earn the given returns. This forces
them to productively employ the capital. This will also motivate mangers to return the
excess cash o the shareholders in the absence of positive NPV projects.

C. Reduce the capital cost

The EVA improves when we employ a given level of capital to earn a given level of profit;
if the cost of capital can be reduced. This drives managers to be careful while financing
the investments

When managers do one or more of the above the value of the firm increases. So improving EVA
theoretically improves the value of the firm and hence is a good measure of managerial /corporate
performance

The EVA’s strongest selling point is that it closely tracks increases or declines in market value’. So,
over time, a company that increases decreases its EVA will also increase or decrease its
shareholder wealth

The EVA is thought to have all the characteristics of then appropriate performance measure as it
considers, in its computation;

a. the amount of capital invested

b. the return earned on the capital and
c. cost of capital (WACC) – reflecting the risk adjusted required rate of return

and hence EVA is promoted to be a better measure than the Free Cash Flow(FCF), Profit After
Tax(PAT), Earnings Per Share(EPS), Return on Investment(ROI) and Net Operating Profit After
Taxes(NOPAT) as a periodic measure of shareholder wealth creation

3-3. The Relationship between EVA and Market Value:

2
ANOPAT is derived by adding back to the reported net operating profit the non cash items such as
amortization of goodwill increase in bad debt reserve, increase in capitalized R & D costs etc…. To facilitate
quick understanding, its simplest form is used.

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The major attraction with EVA is that it is linked to the value of the firm and hence capable of
signaling the value creation or otherwise of it

It is not too uncommon that the Market Value of a firm (Market value of Debt and Market value of
Equity) either exceeds or falls short of its Book Value. The difference is the Market Value Added
(lost). MVA can be arrived at by discounting back the Future EVAs.

MVA = Future EVAs discounted back

Market Value of the firm = Book Value of the firm + MVA

and with simplifying assumption that market and book value of debt are equal,

Market Value of Equity = Book Value of Equity + Market Value Added

The Market Value of equity exceeds its Book value when the MVA is positive and in this case the
Market Value of the equity is said to be at a premium. On the other hand it will be at a discount
when MVA is negative.

Pic 1 captures the link between Market Value, EVA and MVA

Market EVA 1 EVA 2 EVA 3

Market Value = + + + .......................
(1 + k)1 (1 + k)2 (1 + k)3
Value of Added
Equity Book Value
of Equity
Pic 1a. The relationship between MVA and EVA when the market value of the firm is
more than its book value

Market -EVA 1 -EVA 2 -EVA 3

= + + + .......................
Book Value Lost (1 + k)1 (1 + k)2 (1 + k)3
Value of
Market
Equity
Value of
Equity
Pic 1b. The relationship between MVA and EVA when the market value of the firm is less
than its book value

4. The Current Investigation

There have been many papers (Preinreich,1936; Peasnell, 1981; Peasnell,1982; Egginton, 1984;
Stark, 1986) that presented a clear theoretical link between current market value, current book
value and future residual incomes.

There have been many studies in the US testing the above claims--that the EVA is better than its
accounting counterparts; EVA is linked to the market value of the firm. These studies varied in their
rigor and the results

In the Indian context, there had been numerous papers introducing and advocating EVA (Stern,
2001; Jagannathan, 2004; Lawrence and Smith, 2001; Holden and Davey, 1999; Holden and
Davey, 2000; Arundhathi, 2004; Prasanna, 2001; David, 2002; Mayura, 2004; Mahalingam, 2001;
Venkatesh, 2001),

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However, there are very few and restrictive studies testing the above claims in India (Bhalla, 2004;
Meenakshi, 2001; Swain, Mishra and Mukesh, 2002;Venkateswarlu and Nitish, 2004; Banerjee,
2000)

Though few Indian Companies joined the band wagon of their American counterparts in adapting
EVA based corporate performance systems, many other are hesitating as there is no strong
evidence that the EVA system works in India. In the above Context, there is an immediate need for
a comprehensive and elaborate study to ascertain whether the above claims hold in the Indian
context?

This gap in the literature is the primary and strong motivations for this study. So it is proposed to
make an empirical analysis to examine whether EVA has more predictive power relative five
traditional measures

I. Earnings per Share

II. Return on Capital Employed
III. Return on Net Worth
IV. Capital Productivity
V. Labor Productivity

5. Variables & Definitions

5-1. Profit After Tax(PAT)

PATt = Profit After Tax for the year ending t

5-2. Provision for Taxes(PTAX)

PTAXt = Provision for Taxes for the year ending t

5-3. Interest Expense(INT)

INTt = Interest Expense for the year ending t

5-4. Profit Before Taxes(PBT)

PBTt = Profit Before Taxes for the year ending t

5-5. Profit Before Interest and Taxes(PBIT)

PBTt = Profit Before Interest and Taxes for the year ending t

5-6. Non-Recurring Expenses(NRE)

NREt = Non-Recurring Expenses for the year ending t

5-7. Non-Recurring Income(NRI)

NRIt = Non -Recurring Income for the year ending t

5-8. Equity Share Capital(ESC)

ESCt = Book Value of Equity Share Capital at (the end of year) t

5-9. Reserves & Surplus(RS)

RSt = Reserves & Surplus at (the end of year) t

5-10. Revaluation Reserves(RR)

RRt = Revaluation Reserves at (the end of year) t

5-11. Accumulated Losses(AL)

ALt = Accumulated Losses at (the end of year) t

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5-12. Miscellaneous Expenditure(ME))

MEt = Miscellaneous Expenditure at (the end of year) t

5-13. Total Debt(TD)

TDt = Total interest bearing (both long & short term) Borrowings at (the end of year) t

5-14. Earnings Per Share(EPS)

EPSt = Earnings Per Share for the year ending t

5-15. Effective Tax Rate (ETR)

ETRt = Effective Tax Rate for the year ending t

Provision for Taxes PTAX t

ETRt = =
Profit Before Taxes PBTt

5-16. Cost of Debt(Post Tax)(Kd)

kdt = Post Tax Cost of Debt for the year ending t

INTt Begining TD + Ending TD

Kd t = Where Average Debt =
Average Debt 2

5-17. Net Operating Profit After Taxes(NOPAT)

NOPATt = Net Operating Profit After Taxes for the year ending t

NOPTAt = PATt + PTAXt + INTt + NRIt - NREt

5-18. Net Worth(NW)

NWt = Net Worth at (the end of year) t

NWt = ESCt + RSt - RRt - ALt - MEt

5-19. Economic Capital(EC)

ECt = Economic Capital at (the end of year) t

ECt = NWt + TDt

FCFt = CPt + DEPt

5-20. Capital Productivity(Kp)

Net Sales + Change in Stock − Raw Material, Stores etc - Power & Fuel Expenses
Kp =
Net Fixed Assets

5-21. Labour Productivity(Lp)

Net Sales + Change in Stock − Raw Material, Stores etc - Power & Fuel Expenses
Lp =
Salaries & Wages

5-22. Risk Free Rate(Rf)

Rft = Risk Free Rate for the year ending t

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5-23. Market Return (Rm)

Rmt = Return on Market for the year ending t

5-24. Beta (β)

βt = Beta for the year ending t

βt is computed by regressing the monthly returns of the stock with that of the
Sensex in the preceding 60 months

Let Rsj represent the return on the stock for the month j, j=1, 2, …….60

Let Rmj represent the return on the Sensex for the month j, j=1, 2, …….60

COV ( Rsj , Rmj )

β=
VAR ( Rmj )

5-25. Cost of Equity(Ke)

Ket = Cost of Equity for the year ending t

Ket=Rft+(Rmt-Rft)βt

5-26. Weighted Average Cost of Capital(k)

kt = Weighted Average Cost of Capital for the year ending t

kt=(ANW/ACE)ke+(AD/ACE)kd

5-27. Economic Value Added(EVA)

EVAt = Economic Value Added for the year ending t

EVAt=NOPATt - kt.ECt-1

5-28. Return on Capital Employed(ROCE)

ROCEt = Return on Capital Employed for the year ending t

EBITt (1 − ETR ) Begining CE + Ending CE

ROCE t = Where ACE =
Average Capital Employed 2

5-29. Return on Net Worth(RONW)

PATt Begining NW + Ending NW

RONWt = Where ANW =
Average Net Worth 2

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6. The Sample & Regression Models

6-1. The Sample

The sample selection stared with a universe of all the 4730 companies listed in BSE. Companies in
Banking (43) & finance (750) categories and those with no industry type classification (7) are
removed, narrowing the universe to 3930 companies. From this the largest 1500 companies,
identified by their average market capitalization between April 1, 2005, and March 31, 2006 were
retained.

From among the 1500, those for which the Betas coefficients could not be calculated for more than
3 years, Market value figures not available for more than 1 year and EVA could not be computed for
more than 2 years were eliminated, bringing the sample to 1123. Form this 1000 companies were
randomly selected

The following tables capture the calcification of the 1000 sample companies in various dimensions

Cumulative
Incorporation Frequency Percent Valid Percent
Percent
1951-1970 183 18.3 18.3 18.3
1971-1990 520 52.0 52.0 70.3
Post 1990 144 14.4 14.4 84.7
Pre 1951 153 15.3 15.3 100.0
Total 1000 100.0 100.0
Table 1 Sample Companies by the year of incorporation

Cumulative
Industry Type Frequency Percent Valid Percent
Percent
Manufacturing 857 85.7 85.7 85.7
Services 143 14.3 14.3 100.0
Total 1000 100.0 100.0
Table 2 Sample Companies by Industry Type

BSE Listing Cumulative

Frequency Percent Valid Percent
Group Percent
A 128 12.8 12.8 12.8
B1 351 35.1 35.1 47.9
B2 184 18.4 18.4 66.3
S 222 22.2 22.2 88.5
T 63 6.3 6.3 94.8
TS 43 4.3 4.3 99.1
Z 9 .9 .9 100.0
Total 1000 100.0 100.0
Table 3 Sample Companies by the BSE Listing Group

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Cumulative
Industry Frequency Percent Valid Percent
Percent
Automobile 74 7.4 7.4 7.4
Chemicals 134 13.4 13.4 20.8
Computer Software 30 3.0 3.0 23.8
Construction 47 4.7 4.7 28.5
Diversified 19 1.9 1.9 30.4
Drugs and
59 5.9 5.9 36.3
Pharmaceuticals
Food and Beverages 66 6.6 6.6 42.9
Hotels and Restaurants 19 1.9 1.9 44.8
Iron & Steel 55 5.5 5.5 50.3
Machinery and
146 14.6 14.6 64.9
Equipment
Mining and Quarrying 23 2.3 2.3 67.2
Miscellaneous 59 5.9 5.9 73.1
Other Manufacturing 99 9.9 9.9 83.0
Rubber and Plastics 44 4.4 4.4 87.4
Textiles 80 8.0 8.0 95.4
Trading 29 2.9 2.9 98.3
Transport 17 1.7 1.7 100.0
Total 1000 100.0 100.0
Table 4 Sample Companies by Industry

Cumulative
Region Frequency Percent Valid Percent
Percent
Central 57 5.7 5.7 5.7
East 96 9.6 9.6 15.3
North 148 14.8 14.8 30.1
North East 6 .6 .6 30.7
Other 12 1.2 1.2 31.9
South 227 22.7 22.7 54.6
West 454 45.4 45.4 100.0
Total 1000 100.0 100.0
Table 5 Sample Companies by the Region

For each of the companies, the data is collected on several variables are collected from CMIE
Prowess database and few others were calculated form the CMIE variables (See Variables &
definitions). The time span of the data was 1994-2006.

Finally the data resulted in 6000 company years (on 1000 companies for 6 years 2001-2006).

6-2. The Regression Models

The following regression models were run to investigate the strength of relationship between the
market value and each of the independent variables.

I. Market Value = a + b (EPS)

II. Market Value = a + b (ROCE)

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III. Market Value = a + b (RONW)

IV. Market Value = a + b (Kp)
V. Market Value = a + b (Lp)
VI. Market Value = a + b (EVA)

7. Results of the Study

It is surprising that none of the traditional independent variables are found to be explaining any
variation in the market value added. EVA emerged ads the best predictor by explaining 44% of the
variation in MVA (see Table 6 )

Correlation with R Adjusted R Std. Error of

Variable
MVA Square Square the Estimate
RONW .009 .000 .000 3730.55
ROCE .009 .000 .000 3730.21
EPS .006 .000 .000 3730.95
Kp .019 .000 .000 3729.98
Lp .001 .000 .000 3731.02
EVA .665 .442 .442 2786.14
Table 6 : Correlation of key variables with MVA

When a t test is formed to examine the significance of the regression models, Except EVA none of
the variables had any significance even at 15% level. Table 7 details the summary of the regression
models

Unstandardized Coefficients Std. Coeff. t Sig.

Variable
B Std. Error Beta

RONW (Constant) 498.78 50.22 9.932 .000

RONW 26.23 40.10 .009 .654 .513

ROCE (Constant) 497.591 50.254 9.902 .000

ROCE 47.304 71.879 .009 .658 .510

EPS (Constant) 498.341 50.260 9.915 .000

EPS .049 .105 .006 .466 .641

Kp (Constant) 476.627 52.562 9.068 .000

Kp 13.710 9.481 .019 1.446 .148

Lp (Constant) 498.320 51.374 9.700 .000

Lp .105 1.255 .001 .084 .933

EVA (Constant) 322.284 37.595 8.572 .000

EVA 7.322 .111 .665 66.135 .000
Table 7 : Regression models of key variables with MVA

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8. Conclusion
EVA emerged as the better predictor of market value compared to other accounting measures.

While the results of this study are similar to that of Lehn, and Makhija(1997), O’Byrne(1996), Stark
and Thomas(1998) in establishing EVA as having better correlation with the market value compared
to the accounting measures. However they are in contradiction to Farzad, Joe and Julla(2000),
Chen and Dodd (1997& 2001), Biddle, Bowen and Wallace(1996), Linda (2000/2001), Swain et
al.(2002), Malhotra(2001) who declare “EVA is not a better predictor of market value”

EVA is gaining recognition as fundamental measure of company performance despite the fact that it
has been in existence for a relatively short period of time.
.

9. References
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03. Damodaran, Aswath. 2002. Corporate Finance, John Wiley & Sons,

04. Egginton, D., 1984. In Defense of Profit Measurement: Some Limitations of Cash Flow and
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05. Farzad Farsli, Joe Degel , Julla Degner.2000,Economic Value Added (EVA )and Stock Returns,
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15. O’Byrne, Stephen F., 1996. EVA and Market Value, Journal of Applied Corporate Finance, Vol
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