Evaluating EVA Based Valuation Models in Explaining Market Value of Equity

Abstract

Large numbers of studies are conducted on EVA since the late 20th century to the date, where most of the researchers compared the efficiency of EVA as periodic performance measure with accounting measures and reported controversial results. This study brings uniqueness by examining the performance of the EVA based valuation model by comparing the efficiency of earnings valuation model with EVA based valuation model under the assumption of constant required return (normal market return, NMR). Next, this study focuses more on the EVA valuation model because of the growing popularity of EVA and less number of studies conducted on EVA valuation model. Stewart (1991) formulated EVA based valuation model under the assumption of a constant normal market return(NMR) to determine the expected market value of equity by adding book value of equity with the present value of EVAs. The assumption of constant normal market return is not well accepted by several researchers. They elucidated that normal market return never remains constant, and other valuation models (dividend discounted model and discounted cash flow model) perform better under varying normal market returns compared to the constant normal market return. However, the EVA valuation model that is formulated under constant normal market returns cannot be implemented under varying normal market returns. This study explores the option of implementing EVA based valuation model under varying normal market return and observes that by replacing book value of equity with the present value of normal market earnings, the valuation model can be implemented under varying normal market return, where normal market earnings can be determined by multiplying normal market return with the book value of equity. This study further examines whether EVA based valuation model under varying normal market returns outperforms the EVA valuation model suggested under constant normal market return. The statistical analysis has been conducted by considering the sample data of 69 large-cap, 88 midcap and 79 small-cap companies from 2002 to 03 to 2016-17 selected from BSE 500 companies to find whether earnings valuation model outperforms EVA based valuation model that is suggested under the constant normal market as well as to find whether EVA based valuation model under varying normal market return outperforms EVA based valuation model suggested under constant normal market return. The analysis is conducted across the years and on a year-wise basis. The results of statistical analysis indicate that the earnings valuation model outperforms EVA based valuation model under the assumption of constant normal market return, and EVA based valuation model under varying normal market return outperforms EVA based valuation model suggested under constant normal market return in explaining the market value of equity. The results of statistical analysis are also reconfirmed through the graphical presentation of the market value of equities and the expected market value of equities determined by each of the valuation models. This study suggests that EVA based valuation model can be implemented under the scenario of changing normal market return and maintains a better association with a market value of equity compared to existing EVA based valuation model suggested under constant normal market return. Furthermore, the mathematical equation of revised EVA valuation model (addition of the present value of normal market earnings with the present value of EVAs) clarifies that present value of EVAs finds economic value added by subtracting normal market value of equity (present value of normal market earnings) from the market value of equity which is consistent with the objective of EVA that determines economic profit over a specific period by subtracting normal market earnings from company-specific earnings. However, the mathematical equation of the existing EVA based valuation model suggests that the present value of EVAs determines value added (not economic value added) by subtracting book value of equity from the market value of equity which is inconsistent with the objective of EVA. Thus, the revised EVA valuation model eliminates the confusion lies with the present value of EVAs.