EVA(TM) EPS, ROA and ROE as Measures of Performance in Australian Banks: A Longitudinal Study

AbstractThis research empirically tests the relative and incremental information content of performance measures EVA, EPS, ROA and ROE against the Market Value of the shares in the four major Australian banks. Data was obtained from database sources for the purpose of calculating the EVA and extracting the EPS, ROA, ROE and Share Market Value of the four major banks in Australia for the years 2003 to 2011.Two null hypotheses were derived from the literature and tested using the Multiple Linear Regression method. In contrast to results commonly reported, no significant relationship was found between EVA and the market value in terms of relevant information content. However, the incremental information content of EVA was found to be significant in the model tested. This study did not test the different models for calculating EVA which future research may investigate. Future research may also examine more performance measures in the model.KeywordsEconomic Value AddedRelative Information ContentIncremental Information ContentAustralian Banking FirmsIntroductionThe balance sheet is traditionally considered to provide the basis for determining the wealth perspective of shareholders, however, it is only through the application of ratios that the measurement of changes to shareholder wealth are revealed for assessment. Traditional accounting ratios such as return on assets (ROA) and earnings per share (EPS) have been found to provide earnings information (Yee, 2007) but have been criticised for failing to consider differences in earnings capability due to variations in the cost of capital (Jackson, 1996). This is especially important when assessing the relevance of earnings to shareholder wealth.To address the shortcomings of the traditional ratios Stern and Stewart (1993) proposed the application of the economic value added model (EVA(TM)). This model makes allowances for the cost of capital, both equity and debt, as well as adjusting for any research and development costs expensed rather than capitalised. This approach has been claimed to provide a useful measure for better understanding the earnings performance in terms of value-relevance (Chen and Dodd, 2001; Ratnatunga and Montali, 2008). The return on assets (ROA) and the earnings per share (EPS) however continue to be reported in the popular financial press. Additionally, the EPS is a ratio that must be included in the financial report of all companies that are designated as either a reporting entity, as defined by the (Australian and International Accounting Standards or a disclosing entity as defined by the Australian Corporations Legislation. Whilst the EPS has the mantle of being a mandatory ratio no such requirement exists for the reporting of EVA. In fact the financial reports of Australian companies make no allowance for the inclusion or the calculation of EVA. If as the literature claim's EVA is a superior method for measuring performance and assessing future performance then it would seem to be an apt time to address this oversight by empirically examining the differences if any between EVA as distinct from ROA and EPS.Literature Review on EVA ModelEVA is an acronym for the term economic value added (EVA), which is the registered tradename held by Stern Stewart and Company and is their version of a metric to measure a concept commonly referred to as residual income (Biddel, Bowen and Wallace, 1999). The notion of residual income is based on the premise that, in order for a firm to create wealth for its owners, it must earn more on its total invested capital than the cost of that capital. In contrast, traditional accounting measures net income as "profits" net of interest expense on debt capital, by comparison residual income measures "profits" net of the full cost of both debt and equity capital (Biddel, Bowen and Wallace, 1999). In defence of EVA Jackson (1996) argued that the benefits of using EVA in analysis of shares was that it focused on operating cash flow rather than just earnings per share (EPS), which can be manipulated in a variety of ways by managers and their accountants. …