Volume 18, Number 3 Article by Pitabas Mohanty September, 2006
Modified TVA-based Performance Evaluation :
With the increasing popularity of value-based management, a large number of companies are using EVA as a measure of corporate performance. The EVA-based performance measurement system is however often criticised as an incorrect measure of corporate performance because the market forms expectations on the market value of the company and not on the book value, as EVA seems to indicate. Secondly, EVA does not seem to capture the effect of either the periodic cash flows or the capital gains, which largely influence the expectations formed by the market. Thirdly, it is argued that EVA is an accounting based performance measure and hence does not accurately capture the performance of the companies. EVA-based management compensation systems are also criticised on the grounds that they lead to dysfunctional behaviour on the part of the top management of the company. In particular, it is argued that EVA-based management compensation systems may discourage forward-looking expenditures like capital expenditure and R&D expenditure. This paper suggests a modified measure based on EVA (Modified TVA) that addresses these issues.
The paper shows that EVA is not the true measure of excess returns generated by a company. However, the true excess return or ‘true value added’ cannot be used as a measure of corporate performance for the simple reason that it mixes up firm performance with stock market performance. Thus the capital gains during recession years for a company may be negative even when the management reported better-than-industry-average operating performance. In the proposed Modified TVA, the cost of capital is replaced with the conditional cost of capital, which is estimated after accounting for the performance of the industry and the economy. It is suggested that this modified measure not only addresses the shortcomings of an EVA-based management compensation system, but also addresses some of the shortcomings of an ESOP-based management compensation system.
Reprint No 06305