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MANAGEMENT AND ACCOUNTING WEB |
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Clinton, B. D. and S. Chen. 1998. Do new performance measures measure up? Management Accounting (October): 38, 40-43. Summary by Hanna Morales |
Three relatively new performance measures are analyzed and evaluated in this article to examine their correlation with stock prices and stock returns. In addition, the authors examine any truths and/or exaggerations claimed by consulting groups supporting these measurements. The three measures are:
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Measure |
Defined |
| 1. Stern
Stewart’s Economic Value Added (EVA®) |
Operating income - Cost of capital |
| 2. Boston Consulting Group’s Cash Flow Return on Investment (CFROI) |
Operating cash flow ÷ Beginning capital |
| 3. Residual Cash Flow (RCF). | Operating cash flow - Cost of capital |
Other measurements analyzed and evaluated include traditionally reported
measures such as, Operating Income and Cash Flow, and the traditionally used
Return on Investment (ROI).
The authors selected a sample of 325 firms with the available variables to be analyzed for the years 1991 to 1995. They consistently defined all items of the measurements in order to be comparable then, conducted the correlation analysis to stock prices and stock returns. The results are summarized in Exhibits 1 & 2. The correlations are significant at a level of 1%.
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EXHIBIT 1 |
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All
Years |
Average |
1995 |
1994 |
1993 |
1992 |
1991 |
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Sample Size |
1,625 |
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325 |
325 |
325 |
325 |
325 |
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OIt (Operating
income after tax per sharet) |
0.162 |
0.265 |
0.163 |
0.518 |
0.477 |
0.119 |
0.046 |
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AOIt (S.S.
adjusted operating income after tax per sharet) |
0.558 |
0.544 |
0.504 |
0.596 |
0.580 |
0.557 |
0.481 |
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CFt (Operating
cash flow per sharet) |
0.550 |
0.559 |
0.490 |
0.587 |
0.639 |
0.605 |
0.473 |
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RIt
(Residual income per sharet) |
0.004 |
-0.012 |
0.065 |
0.029 |
-0.023 |
-0.057 |
-0.074 |
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EVAt (Economic
value added per sharet) |
-0.006 |
-0.054 |
0.106 |
-0.057 |
0.145 |
-0.097 |
-0.076 |
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RCFt (Residual
cash flow per sharet) |
0.382 |
0.357 |
0.397 |
0.393 |
0.394 |
0.336 |
0.265 |
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ROIt (Return
on investmentt) |
0.062 |
0.060 |
0.058 |
0.007 |
0.083 |
0.104 |
0.046 |
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AROIt (S.S.
adjusted return on investmentt) |
0.168 |
0.143 |
0.175 |
0.103 |
0.054 |
0.167 |
0.217 |
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CFROIt (Cash
flow return on investmentt) |
0.101 |
0.109 |
0.196 |
0.079 |
0.065 |
0.093 |
0.112 |
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t End
of current period. S.S. = Stern Stewart |
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EXHIBIT 2
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All Years |
Average |
1995 |
1994 |
1993 |
1992 |
1991 |
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Sample Size |
1,625 |
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325 |
325 |
325 |
325 |
325 |
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OI/Pt-1
(Operating income after tax per sharet-1) |
0.125 |
0.200 |
0.189 |
0.233 |
0.300 |
0.226 |
0.054 |
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AOI/Pt-1
(S.S. adjusted operating income after tax per sharet-1) |
0.272 |
0.266 |
0.271 |
0.155 |
0.264 |
0.351 |
0.287 |
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CF/Pt-1
(Operating cash flow per sharet-1) |
0.313 |
0.278 |
0.239 |
0.182 |
0.219 |
0.562 |
0.187 |
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RI/Pt-1
(Residual income per sharet-1) |
0.040 |
0.106 |
0.142 |
0.150 |
0.164 |
0.070 |
0.005 |
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EVA/Pt-1
(Economic value added per sharet-1) |
-0.064 |
-0.018 |
-0.098 |
0.057 |
0.078 |
-0.078 |
-0.051 |
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RCF/Pt-1
(Residual cash flow per sharet-1) |
0.232 |
0.225 |
0.215 |
0.147 |
0.139 |
0.496 |
0.130 |
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ROI/Pt-1
(Return on investmentt-1) |
0.096 |
0.123 |
0.096 |
0.156 |
0.131 |
0.074 |
0.156 |
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AROI/Pt-1
(S.S. adjusted return on investmentt-1) |
0.130 |
0.000 |
0.144 |
0.214 |
0.027 |
-0.026 |
-0.360 |
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CFROI/Pt-1
(Cash flow return on investmentt-1) |
0.107 |
0.150 |
0.144 |
0.131 |
0.049 |
0.143 |
0.282 |
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Returnt
= (pricet - pricet-1 + dividendt)/pricet-1
Pt-1 = Beginning of period price.
t = End of current period.
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t-1
= Beginning of current period.
S.S. = Stern Stewart |
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As a result, operating cash flow and adjusted operating income reported the best-performing categories and have higher association to stock price and stock return compared to the others. Of the three new measurements, residual cash flow (RCF) is the only one that showed encouraging correlations. The more popular RI and ROI, and the most recently highly promoted EVA® and CFROI produced either insignificant or inconsistent correlations and therefore “indistinguishable in their relative lack of contribution to assessing firm value (41).”
Cash flow ROI (CFROI) avoids accounting distortions by excluding depreciation. It also provides a moving target based on assumptions about reinvestment that may or may not be true. Also, CFROI does not eliminate the hurdle rate problem, in which companies set an acceptable rate of return and assess performance based on the actual rate achieved. Thus, companies are discouraged from investing in projects that would be expected to achieve a lower return, compared to the presently employed assets, even if it exceeds the hurdle rate. It would result in a greater positive cash flow for the company, but lower total rate on the portfolio of investments. Because it lowers the overall performance evaluation criterion, it discourages approval of the project even though it would be beneficial to the whole company.
EVA®, on the other hand, includes depreciation twice in the earnings and investment portion. In addition, EVA® does not adequately consider the cost of capital in valuing stock, much like RI, and like CFROI, its target is based on assumptions about reinvestment. Plus, contrary to the claims, and as proven by the analyses, it is not considerably associated with either stock returns or stock price but rather, “it drives stock prices (p. 41).” The authors then suggest residual cash flow (RCF) as the best choice to use in linking profit to capital and ultimately to market value. RCF maintains the advantages of using a cash-based and a residual-based measure. “The consideration of the cost of capital is present and subtracted from cash flow to arrive at a residual result (p. 43)” in dollars. The residual cash flow measure is consistent with capital asset investment planning and is already stated in terms of cash so adjustment to remove accounting distortions is not necessary.
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