10.

1177/1096348005284268
Kim / EVA OF
JOURNAL AND TRADITIONAL
HOSPIT ACCOUNTING
ALITY & TOURISM MEASURES
RESEARCH

EVA AND TRADITIONAL ACCOUNTING

MEASURES: WHICH METRIC IS A
BETTER PREDICTOR OF MARKET
VALUE OF HOSPITALITY COMPANIES?
Woo Gon Kim
Oklahoma State University

This study tests the hypothesis that Economic Value Added (EVA) is more highly associated
with hospitality firm values than with traditional performance measures. The purpose of
this study is to provide empirical evidence on the relative and incremental information con-
tent of EVA and traditional performance measures, earnings, and cash flow. Regression
analysis tests the information content of EVA and indicates that earnings are more useful
than cash flow in explaining the market value of hospitality firms. EVA itself has very little
explanatory power. Incremental information content tests show that EVA makes only a
marginal contribution to information content beyond earnings and cash flow. Overall, the
results do not support the hypothesis that EVA is superior to traditional accounting
measures in association with equity market value.

KEYWORDS: Economic Value Added (EVA); earnings; cash flow; relative informa-
tion content; incremental information content; hospitality firm values

In recent years, shareholder activism reached unprecedented levels and led to

increased pressure on firms to maximize shareholder value (Bacidore, Boquist,
Milbourn, & Thakor, 1997). However, despite their best efforts, many companies
failed to create shareholder wealth. Consulting companies such as Stern Stewart
& Company (EVA),1 Boston Consulting Group’s HOLT Value Associates (cash-
flow return on investment: CFROI), KPMG Peat Marwick (economic value man-
agement: EVM), and Marakon Associates (discounted economic profits: EP)
have developed value-based performance measures in order to overcome the
shortcomings of traditional accounting performance measures such as earnings
and cash flow from operations (Biddle, Bowen, & Wallace, 1997). The most pop-
ular value-based performance measure is Stern Stewart’s Economic Value Added
(EVA).
EVA is the financial performance measure that most accurately reflects a cor-
poration’s true profit (Stewart, 1991). EVA is the difference between a company’s
net operating income after taxes and its cost of capital of both equity and debt

Journal of Hospitality & Tourism Research, Vol. 30, No. 1, February 2006, 34-49
DOI: 10.1177/1096348005284268
© 2006 International Council on Hotel, Restaurant and Institutional Education
34

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 Kim / EVA AND TRADITIONAL ACCOUNTING MEASURES 35

(Stewart, 1994). If a company’s return on capital exceeds its cost of capital, it is

creating true shareholder value. Companies that consistently generate high EVAs
are valued most highly by shareholders (Dierks & Patel, 1997). Market value
added (MVA) is equal to the present value of the firm’s expected future EVA.
MVA shows whether a firm has added value to the capital it has obtained from
shareholders and lenders (Milunovich & Tsuei, 1996). Firms with positive EVA
momentum are more likely to see their share price go up over time as the rising net
profits of the overall capital costs increase in the firm’s MVA. The objective of
EVA is to understand which business units best leverage their assets to generate
returns and maximize shareholder value. Other EVA applications include setting
goals and measuring performance, communicating with investors, evaluating
strategies, allocating capital, valuing acquisitions, and determining incentive
bonuses (Stewart, 1994).
Corporate managers and the business press have shown great interest in the use
of EVA as a measure of performance. This new metric is a profit measure based on
the true economic income. The principal feature of EVA measure is that, unlike
traditional accounting measures, it reduces income by a charge for the cost of cap-
ital that includes the cost of the equity capital provided by owners. This charge has
long been included in certain traditional measures of income that mainstream
economists have used for more than a century (McIntyre, 1999). A company’s
value is created only when the return on the invested capital is higher than its cost
of capital. The opposite is also true. When the return on the invested capital is less
than the cost of capital, a firm’s value is undermined. EVA has gained widespread
acceptance and credibility not only as an operational performance metric, but also
as a way in which management’s decisions contribute value to an organization.
It has even been predicted by Zarowin (1995) that EVA may replace Earnings
Per Share (EPS) in The Wall Street Journal’s regular stock and earnings reports.
Thus, it is not surprising that firms are increasingly hopping on the EVA band-
wagon (Chen & Dodd, 2001). Eli Lilly, Polaroid, Coca-Cola, Sprint, Toys R Us,
and Whirlpool have adopted EVA as a guiding principle for performance mea-
surement (Biddle et al., 1997). Specifically, EVA has been used as a management
compensation tool and for management decision-making in capital budgeting.
Financial investment firms are relying upon EVA to determine the best companies
in which to invest. Stewart (1991) argued that such traditional measures as earn-
ings, earnings per share (EPS), return on equity (ROE), and return on investment
(ROI) are misleading measures of corporate performance. EVA, in contrast, is
what drives stock prices and is conspicuous as the single best measure of wealth
creation (Stewart, 1994).
Despite wide interest in EVA, there is a dearth of empirical evidence on the
efficacy of this measure versus other measures of firm performance in the hospi-
tality industry. The relevance of this alternative performance measurement to tra-
ditional accounting measurement has not been fully explored. Academic research
has not established EVA’s correlation to market value and stock returns. The evi-
dence from previous studies is mixed and has not resolved the debate over
performance measures.

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36 JOURNAL OF HOSPITALITY & TOURISM RESEARCH

The objective of this study is to investigate whether EVA is a better predictor

than currently mandated performance measures, earnings, and operating cash
flow, in explaining the market value of hospitality firms. EVA was compared to
traditional accounting performance measures. The remainder of this article is
organized as follows: calculation of EVA, summary of empirical studies, the
adoption of EVA technique in the hospitality industry, the hypotheses, and the
methodology are discussed, followed by empirical results, conclusions, and
limitations and suggestions for future research.

CALCULATION OF EVA

EVA can be expressed as

EVA = NOPAT – (WACC × IC) (1)

where

NOPAT = net operating profit after tax

WACC = weighted average cost of capital
IC = invested capital.

The information needed to compute EVA is obtained from accounting data.

However, due to drawbacks in conventional Generally Accepted Accounting
Principles (GAAP), accounting information must be adjusted. These adjustments
are made in order to avoid distortions in accounting information (Prober, 2000).
The first step in computing EVA is finding the net operating profit after tax
(NOPAT). NOPAT is a measure of a firm’s profit generation ability from recurring
business activities and disregarding its capital structure (Dierks & Patel, 1997).
NOPAT is profits derived from a company’s operations after taxes but before fi-
nancing costs and noncash-bookkeeping entries. Invested capital (IC) is defined
as assets (net of accumulated depreciation) invested in going-concern operating
activities, or equivalently, interest-bearing debt and equity capital at the begin-
ning of the period (net of nonoperating capital). After WACC is estimated, EVA
cost of capital can be produced by IC multiplied by WACC. This EVA cost of
capital will be deducted from NOPAT.
An alternative EVA calculation from Equation 1 is expressed below:

EVA = (NOPAT/IC × IC) – (WACC × IC) (2)

= (ROIC × IC) – (WACC × IC).

Therefore, EVA is also explained by the following equation:

EVA = (ROIC – WACC) × IC (3)

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 Kim / EVA AND TRADITIONAL ACCOUNTING MEASURES 37

where

ROIC = return on invested capital (NOPAT/IC)

WACC = weighted average cost of capital
IC = invested capital (total average capital).

EVA is positive if ROIC exceeds the cost of financing. In this case, the com-
pany has created shareholder value. On the other hand, when EVA is negative, the
company has lost value.
The computation of NOPAT can be explained by the following equation:

NOPAT = EBIT – Tax (4)

where

EBIT = earnings before interest and income tax

Tax = corporate income tax.

Net operating profit after tax (NOPAT) is pre-interest but after-tax corporate
earnings. A way to calculate NOPAT is the Earnings Before Interest and Tax
(EBIT) minus taxes. The terms Operating Profit (Income) and Operating Earn-
ings are widely used instead of EBIT. In other words, NOPAT is the amount of net
profit after tax plus interest expense.
There are as many as 164 items for potential adjustment for NOPAT but only a
few adjustments are necessary to provide a good measure of EVA (Prober, 2000).
Stewart (1991) recommends that the adjustments to the definition of EVA be
made only if (a) the amounts are significant, (b) the adjustments have a material
impact on EVA, (c) operating people can readily grasp it, and (d) the required
information is easy to track. The number of recommended adjustments has been
declining in recent years because backtesting and simulation have shown that
most of the proposed adjustments have little or no impact on profits (Young,
1999).
The adjustment items recommended by Johnson (2001) include adding the
increase in the LIFO reserves, the increase in the bad debt reserves, the increase in
capitalized R&D, other operating income, and subtracting an estimate of taxes
owed for the period.
Capital begins with the book value of shareholder’s equity. Some adjustments
need to be made to convert accounting capital to economic capital (invested capi-
tal). Interest-bearing debt is added to capital because the debt represents financing
(Johnson, 2001). Deferred income taxes created by increasing deferred tax assets
are added because they are never paid off and thus represent permanent capital.
Deferred income taxes are defined as a balance sheet account that describes the
effect of timing differences between the amount of income taxes that are reported
as due for financial reporting purposes, and the amount of income taxes that are
actually due and payable to the taxing authorities (Young, 1999). Deferred taxes
commonly arise from differences between the amount of depreciation expense

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38 JOURNAL OF HOSPITALITY & TOURISM RESEARCH

recognized for financial reporting purposes and the (greater) amount of deprecia-
tion reported for tax purposes caused by the use of accelerated depreciation meth-
ods. The add-back of accumulated goodwill amortization is consistent with
adding back the deductions on the income statement.
Another important but missing variable in Equation 1 is the calculation of a
firm’s WACC (weighted average cost of capital). WACC is calculated by multi-
plying the cost of each capital component by its proportional weighting and then
summing:

WACC = (E/V) × Ke + (D/V) × Kd × (1 – Tc) (5)

where

Ke = cost of equity (required rate of return for equity)

Kd = cost of debt (required rate of return for debt)
E = the market value of the firm’s equity
D = the market value of the firm’s debt
V = the combined market value of the firm’s equity and debt
E/V = percentage of equity financing employed in the firm’s capital structure
D/V = percentage of debt financing employed in the firm’s capital structure
Tc = the corporate tax rate.

The before-tax cost of debt is estimated by using the promised yield on newly
issued long-term bond of the firm, which is reported in Standard & Poor’s Bond
Guide. The after-tax cost of debt is calculated by multiplying the before-tax cost
by (1 – corporate tax rate). The following equation expresses the cost of equity (Ke):

Ke = Rf+ β (Rm – Rf) (6)

where

Rf = risk-free interest rate

β = beta coefficient
Rm = return on the market portfolio
(Rm – Rf) = market risk premium

Capital Asset Pricing Model (CAPM) is used as a basis for estimating the cost
of equity. The risk-free rate is the 3-month U.S. Treasury bill rate or the monthly
return on 30-day U.S. Treasury bill as a proxy of risk-free rate (Kim, Gu, &
Mattila, 2002). The beta is obtained from the COMPUSTAT database. The market
risk premium is the reward-premium that investors implicitly require for investing
in a diversified portfolio of stocks instead of risk-free treasury bills. It is the differ-
ence between the expected return on a market portfolio and the risk-free rate.
Once those rates, cost of debt and cost of equity, are determined, they are com-

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 Kim / EVA AND TRADITIONAL ACCOUNTING MEASURES 39

bined with the relative proportions of capital to calculate the weighted average
cost of capital (WACC).

PREVIOUS EMPIRICAL STUDIES ON EVA

Numerous studies have been conducted since Stern Stewart introduced the
EVA metric in 1989. Most of the research was designed to examine if EVA is more
correlated with stock return or market value than are other traditional accounting
performance measures. Analysis of the EVA literature indicates mixed results.

Controversy in EVA Literature

Some researchers performed empirical analysis to investigate the assertion of
Stern Stewart that EVA is a better performance measure in prediction of stock
returns or market value. EVA, unlike NOPAT or other traditional accounting mea-
sures like net income or earnings per share, is expected to be linked to market
value (O’Byrne, 1996). Despite the evidence provided by EVA advocates (Grant,
1996; Lehn & Makhija, 1997; O’Byrne, 1996, 1997; Uyemura, Kantor, & Pettit,
1996; Walbert, 1994), the results of many empirical studies do not support the
claim that EVA is superior to other traditional accounting performance measures
(Biddle et al., 1997; Chen & Dodd, 2001; Clinton & Chen, 1998; Ray, 2001).
The following studies validate the claim of EVA’s superiority over traditional
performance measures in its association with stock returns or firm values. Grant
(1996) studied the relationship between EVA and corporate valuation. The sam-
ple consisted of 983 U.S. companies from Stern Stewart’s performance database
for 1993. He found that the EVA-to-capital ratio (EVA/CAPITAL) explains
approximately 32% of the variable MVA-to-capital ratio (MVA/CAPITAL).
Grant used the MVA- and EVA-to-capital ratios to adjust for firm size. His study
suggests that EVA has a significant impact on the market-value-added of a firm
and this wealth effect stems from the company’s positive residual return on
capital.
Like the above-mentioned studies, the research of Uyemura et al. (1996) also
shows a strong relation between EVA and MVA. The authors analyzed the relation
of earnings per share (EPS), net income (NI), return on equity (ROE), return on
assets (ROA), and EVA, with MVA, during the period of 1986 to 1995 for the 100
largest bank holdings. The correlations between these performance measures and
MVA were as follows: EVA 40%, ROA 13%, ROE 10%, NI 8% and EPS 6%.
O’Byrne (1996) analyzed industrial companies and found that EVA is superior
to earnings in explaining firm value. The sample consisted of 6,551 firm-year
observations, for the period of 1985 to 1993. He estimated two simple regressions
where market value divided by capital was the dependent variable. The independ-
ent variable was EVA in the first regression and NOPAT in the second. All vari-
ables were standardized by capital at the beginning of the period. The results
reported an adjusted R 2 of 56% for the EVA regression and 33% for the NOPAT
regression. The empirical findings suggest that EVA outperforms earnings
(NOPAT) in explaining firm values.

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40 JOURNAL OF HOSPITALITY & TOURISM RESEARCH

Milunovich and Tsuei (1996) applied the EVA measure to the computer indus-
try. They found that EVA was the most influential variable affecting MVA. EPS
growth came second, and free cash flow was the last variable. Their regression
analysis showed changes in EVA explaining 42% of changes in MVA.
Lehn and Makhija (1997) studied the relation between six performance mea-
sures and stock returns. They used data from 452 U.S. companies from 1985 to
1994. The results revealed that EVA and MVA are effective measures of perfor-
mance. Moreover, the correlation of EVA with stock returns (.59) was slightly
higher than the correlation of MVA (.58), ROE (.46), ROA (.46), or ROS (.39).
Thus, EVA and MVA appear to be somewhat better long-run performance mea-
sures than conventional accounting performance measures.
Some studies refute the assertion that EVA is more highly associated with
stock returns than accounting earnings and operating cash flows. Clinton and
Chen (1998) analyzed the relationship of various performance measures to stock
price and stock returns. In addition to EVA, they examined Cash Flow Return on
Investment (CFROI) and Residual Cash Flow (RCF) as measures worth consider-
ing. They selected 325 companies from Standard & Poor’s 500 and the Stern
Stewart 1996 Performance 1,000 databases and studied the years from 1991 to
1995. EVA was the only measure that did not reveal a consistently significant
association with either stock price or stock return. In the same line, Chen and
Dodd (2001) concluded that the market may place higher reliance on audited
accounting earnings than the unaudited EVA metric did. Their findings failed to
support the assertion that EVA is the best measure for valuation purposes.
Biddle et al. (1997) tested the assertions that EVA is more highly associated
with stock returns and firm values than accrual earnings, and evaluated which
component of EVA, if any, contributed to these associations. The results indicated
that earnings (R2 = 12.8%) were significantly more highly associated with market-
adjusted annual returns than either Residual Income (R2 = 7.3%) or EVA (R2 =
6.5%) and that all three of these measures dominate cash from operations (R2 =
2.8%). Correlations between the independent variables were all positive and sig-
nificant except EVA and RI, which were negatively correlated with cash from
operations (CFO). Earnings before extraordinary items (EBEI) had the highest
correlation with market-adjusted return. The empirical results do not support the
conclusion that EVA dominates earnings in relative information content, and sug-
gest rather that earnings generally outperform EVA.
Even though EVA has been gaining popularity since the 1990s, few studies
have applied it to the hospitality industry. Ganchev (2000) adopted EVA measure-
ment in pursuit of acquisition or development of hotel real estate. In this study, he
provided EVA as a tool to analyze the project’s profitability and to understand
how return on investment changed with shifts in strategy. He also stated that EVA
helps the investor evaluate asset performance in any single year, while the DCF
(Discounted Cash Flow) shows the investment returns over the life of the projects.
The results of the EVA literature are inconclusive. On one hand, some evidence
supports the superiority of EVA to traditional performance measures. On the
other hand, theoretical arguments and empirical evidence questions the
advantages of EVA.

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 Kim / EVA AND TRADITIONAL ACCOUNTING MEASURES 41

Adapting EVA to the Hospitality Industry

The economic and business environments have changed radically during the
past few years. The U.S. hospitality industry has suffered from both the terrorist
attacks of September 11, 2001, and the downturn in the economy (France, 2003).
Top executives of hospitality firms are facing increasingly competitive markets
and complex environments. Traditional accounting performance measures have
become inadequate in light of the new realities (Abdeen & Haight, 2002). Thus,
given the changes within and around the hospitality industry, financial managers
need to be equipped with more powerful and sophisticated corporate performance
measures.
Sequeira (2000) recommended that a financial manager in the hospitality
industry incorporate the EVA technique. He proposed that the EVA can be applied
in the normal decision-making process when reviewing leases, funding for capital
renovations, and analyzing ROI on special projects. A hotel property’s value is
created only when the economic return on the project is higher than its cost of
capital.
To the best of our knowledge, no study in the hospitality industry has investi-
gated if EVA is better at explaining a firm’s market value.

Hypotheses
The primary purpose of this study is to provide empirical evidence on the rela-
tive and incremental information content of EVA and traditional performance
measures. Relative information content comparisons analyze if one measure pro-
vides greater information content than another. Incremental information content
comparisons assess whether one measure provides more information content than
another. The first hypothesis tests the assertion that EVA dominates traditional
performance measures in explaining firm values. Stewart (1994) argues that EVA
is better than its traditional performance measures in explaining changes in
shareholder wealth.

Hypothesis 1: The relative information content of EVA is superior to mandated perfor-

mance measures, earnings, and free cash flow in explaining firm values of hospi-
tality firms.

The relative information content investigates which variables (EVA, NOPAT,

FCF) have greater association with firm value. NOPAT is the amount of net in-
come a company would generate if it had no debt. To get a true reflection of a com-
pany’s operating performance, one would want to take out debt to get a clearer
picture of the situation. Free cash flow (FCF) is the cash that is left over after the
payment of all cash expenses and operating investment required by the firm. It is
the hard cash that is available to pay the company’s various claim holders, in par-
ticular the shareholders. To produce revenue, a firm not only incurs operating ex-
penses, but it also must invest money in real estate, buildings and equipment, and
in working capital to support its business activities. Also, the corporation must

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42 JOURNAL OF HOSPITALITY & TOURISM RESEARCH

pay income taxes on its earnings. The amount of cash that is left over after the pay-
ment of these investments and taxes is free cash flow. The conventional way of as-
sessing the relative information content is to compare the coefficients of determi-
nation (R2) of various simple regressions that analyze the relation between various
performance measures and equity market value.
The second hypothesis refers to the incremental information content.

Hypothesis 2: EVA adds information content to that provided by NOPAT and FCF.

2
To assess incremental information content one analyzes the increase in the R
that arises from the inclusion of more variables in the model.

METHOD

Data Collection and Sample

This study used secondary data, which were collected from Standard & Poor’s
COMPUSTAT database. The researcher attempted to use EVA data from the
Stern Stewart Performance 1,000 databases. However, many hospitality firms
failed to be ranked in this list except for approximately 12 top hotel and restaurant
companies. Thus, the research in this study was carried out through the calcula-
tion of EVA. The data required for this research included accounting information
to derive EVA as well as earnings and cash flow. These traditional accounting
measures were selected based on the findings of previous studies that tested the
relationship between EVA and accounting performance measures.
The sample for this study consisted of 89 publicly traded hospitality firms.
Firms that did not have data for the entire period of 1995 to 2001 were eliminated
from the analysis. The total number of firms with the Standard Industrial Classifi-
cation (SIC) code of 7011 (hotels and motels) was reduced to 66, whereas the
number of firms with the SIC code of 5812 (eating and drinking places) was
reduced to 23. The pooled regression model used a total of 623 firm-year
observations.
To transform accounting income into economic income (NOPAT), some of the
adjustments were adapted from Johnson (2001) and Stewart (1991). Except for
estimated income taxes, other recommended adjustments such as the LIFO
reserves, the bad debt reserves, and capitalized R&D were immaterial or unavail-
able. For the purpose of this study, only estimated income taxes, which are mea-
sured as income taxes payable in COMPUSTAT database, were adjusted from
operating profit to derive NOPAT. To derive invested capital, interest-bearing debt
and deferred income taxes are added to shareholder’s equity. However,
COMPUSTAT database does not provide the information of other accumulated
goodwill amortization.
To calculate a firm’s weighted-average cost of capital, the following variables
were operationalized. The 3-month U.S. Treasury bill rate obtained from the St.
Louis Federal Reserve Bank’s Federal Reserve Economic Data database was used

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 Kim / EVA AND TRADITIONAL ACCOUNTING MEASURES 43

as a proxy of a risk-free rate. There is a continuing dispute over what that premium
should be and whether it should be derived from the arithmetic or geometric mean
of this spread over time. Most service companies use a risk premium of approxi-
mately 7% (Johnson, 2001). Following Stewart’s (1991) methodology, 6% of the
market-risk premium is used for the calculation of the cost of equity.
To test the accuracy of EVA calculation method described above, EVA data
from the Stern Stewart with all necessary adjustments are compared with EVA
calculated in this study. The Pearson correlation coefficients between these two
sets of data for the entire period of 1995 to 2001 showed high correlation with
average correlation coefficients of .76 at the significance level of .01. Therefore,
we can safely conclude that the estimated EVA in this study has significant, posi-
tive association with Stern Stewart’s estimated EVA.

The EVA Regression Models

To measure earnings and cash flow, NOPAT and FCF taken from O’Byrne
(1996) were employed as appropriate accounting performance measures in this
study. To test the predictive power of EVA relative to earnings (NOPAT) and free
cash flow (FCF), three separate simple linear regression models were developed
to examine the relationship between a company’s market value and traditional
performance measures. The EVA model would express a hospitality company’s
market value as a linear function of three independent variables (EVA, NOPAT,
and FCF). To test Hypothesis 1 regarding the relative information content of
EVACAP, NOPATCAP, and FCFCAP that were all standardized by capital, the
following three linear regression models were estimated.

MKTCAP = B0 + B1EVACAP + e
MKTCAP= B0 + B1NOPATCAP + e
MKTCAP= B0 + B1FCFCAP + e

where

B0 = constant
MKTCAP = Market value of Equity / Capital
EVACAP = Economic Value Added / Capital
NOPATCAP = Net Operating Profit After Tax / Capital
FCFCAP = Free Cash Flow / Capital
e = the error terms of regression

To test Hypothesis 2 regarding the incremental information content of

EVACAP, NOPATCAP, FCFCAP, the following multiple linear regression model
is presented as follows:

MKTCAP = B0 + B1EVACAP + B2 NOPATCAP + B3 FCFCAP + e

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44 JOURNAL OF HOSPITALITY & TOURISM RESEARCH

Table 1
Variable Definitions, Means, and Standard Deviations

Variable Definition Mean Standard Deviation

MKTCAP Market value divided by capital 1.348 1.927

EVACAP EVA divided by capital 0.002 0.004
FCFCAP Free cash flow divided by capital 0.032 0.102
NOPATCAP NOPAT divided by capital 0.0964 0.181

Note: EVA = Economic Value Added; NOPAT = net operating profit after tax.

where

B0 = constant
MKTCAP = Market value of Equity / Capital
EVACAP = Economic Value Added / Capital
NOPATCAP = Net Operating Profit After Tax / Capital
FCFCAP = Free Cash Flow / Capital
e = the error terms of regression.

EMPIRICAL RESULTS

To reduce the heteroscedasticity in the data, the researcher deflated all inde-
pendent variables (NOPAT and FCF) and a dependent variable (MKT) by divid-
ing all three variables by capital (equity plus long-term debt). The prediction
errors as a percentage of capital are much closer to a normal distribution than the
prediction errors in absolute dollars (O’Byrne, 1996). The variable definitions,
means, and standard deviations of the four variables appear in Table 1. As shown
in Table 1, the average hospitality firm trades at approximately 1.3 times the book
value of capital and earns a 9.6% rate of return on total capital. However, the aver-
age firm produces EVACAP and FCFCAP that are not different from zero.
In Table 2, relative information content is evaluated by comparing adjusted R2s
from three separate regressions, one for each performance measure, NOPATCAP,
FCFCAP, and EVACAP. First, one should note that all of the regressions are sig-
nificant according to the F statistic at the .01 level. The results suggest that in
terms of relative information content all three performance measures are statisti-
cally significant variables at the level of .01. Adjusted R2s from three regressions
are presented in Table 2. Earnings (NOPATCAP) have the greatest ability to
explain market value with adjusted R2 of 16.9%. Next, FCFCAP has significantly
larger adjusted R2 (14.2%) than does the EVACAP (10.3%). The results of regres-
sion analysis indicate that earnings (NOPATCAP) have the highest explanatory
power, followed by cash flow (FCFCAP). Economic value added (EVA) has a rel-
atively limited explanatory power. The explanatory power of findings of Biddle
et al. (1997) is consistent with this study: earnings (R2 = 12.8%), residual income
(R2 = 7.3%), and EVA (R2 = 6.5%). Thus, the results fail to confirm Hypothesis 1.
Table 3 shows the results of the incremental information content of three per-
formance measures. To detect the presence of first-order autocorrelation among
the residuals of this sample, Durbin-Watson d statistic was used. The d statistic

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 Kim / EVA AND TRADITIONAL ACCOUNTING MEASURES 45

Table 2
Tests of the Relative Information Content of NOPATCAP, FCFCAP, and EVACAP
2
NOPATCAP FCFCAP EVACAP F Adj. R

0.413 (11.15)** 124.31** 16.9%

0.377 (10.03)** 100.66** 14.2%
0.324 (8.422)** 70.93** 10.3%

Note: EVA = Economic Value Added; NOPATCAP = net operating profit after tax divided by
capital; FCFCAP = free cash flow divided by capital; EVACAP = EVA divided by capital. The
dependent variable is the ratio of market value of equity to capital. The independent variables
are net operating profit, free cash flow, and EVA, standardized by the capital. t-statistics are
provided in parenthesis.
** statistically significant at the .01 level.

Table 3
Tests of the Incremental Information Content of NOPATCAP, FCFCAP, and EVACAP

Model 1 Model 2

Independent variables
NOPATCAP 0.316 (8.23)** 0.290 (7.46)**
FCFCAP 0.260 (6.77)** 0.210 (5.15)**
EVACAP 0.137 (3.42)*
R2 .229 .243
Adjusted R2 .226 .240
F-value 0.156** 0.176**
∆R2 — .015
F-value for ∆R2 — 11.692*
Durbin-Watson 2.06 2.05

Note: The dependent variable is the ratio of market value of equity to capital. t-statistics are
provided in parentheses.
* statistically significant at the .05 level. ** statistically significant at the .01 level.

ranges from 2.05 to 2.06. It shows that error terms are serially independent, with
an average error term of zero. To detect the presence of multicollinearity, the vari-
ance inflation factor (VIF) was computed. In general, the VIF cutoff threshold
would be 10 (Hair, Anderson, Tatham, & Black, 1998). The VIF values for all
NOPATCAP, FCFCAP, and EVACAP were 1.206, 1.330, and 1.285, respectively,
which indicated a low degree of multicollinearity among the independent
variables.
The overall increase in R2 is minimal (1.5% increase) between the first regres-
sion on NOPATCAP and FCFCAP and the second regression on all three perfor-
mance measures. Although the contribution of EVA in explaining market value of
hospitality firms is slight, increased R2 is statistically significant at the .05. Thus,
the result accepts Hypothesis 2. In sum, the results show evidence that EVA still
adds incremental information to that provided by earnings and cash flow in
explaining market value of hospitality firms.

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46 JOURNAL OF HOSPITALITY & TOURISM RESEARCH

CONCLUSIONS

Motivated by increased use in practice, media interest, and academic interest,

this study investigated the relationship between EVA and equity market value in
the hospitality industry. The investigator used regression analyses to examine
whether EVA was superior to traditional accounting measures.
Some of the literature argues that EVA increases shareholders’ wealth (Pettit,
1998; Stern, Stewart, & Chew, 1995; Stewart, 1991, 1994). Other studies show
that EVA does not have a significant correlation with MVA and does not dominate
traditional performance measures in explaining market value of hospitality firms
(Biddle et al., 1997; Chen & Dodd, 2001; Clinton & Chen, 1998; Ray, 2001).
The empirical results of this study do not support the claims that EVA is a better
financial tool than traditional accounting measurements in explaining market
value. EVA did not significantly outperform traditional accounting measures in
tests of relative information content. NOPAT and FCF were more highly corre-
lated with market value rather than was EVA. The findings of this study mirrored
the findings of Biddle et al. (1997) and Clinton and Chen (1998) that EVA is not
superior to other accounting measures in its association with firm values. The
results are consistent with the fact that traditional financial statements, ratios, and
traditional performance measures are used to ensure accounting compliance
requirements and as a yardstick for investors to compare prospective investments
in various hospitality companies.
However, there could be possible reasons why the researcher did not detect a
stronger relationship between EVA and market value. First, EVA calculation pro-
cess requires other adjustments to derive NOPAT and invested capital (IC). Not all
recommended adjustments were made to derive NOPAT and invested capital.
Even if previous researchers stated that most of the proposed adjustments have lit-
tle material impact, the scope of adjustment could affect the final value of NOPAT
and EVA. In addition, some data were not available to make adjustments during
the test period.
Second, the market may have failed to recognize the reporting benefits of EVA
through the period the researcher studied. It is clear that stock price is greatly
influenced by expectations of the future, and the EVA pertains to the past. As
more data become available, future studies will be able to assess whether market
participants have come to appreciate EVA.
Third, this research used current realizations of performance measures. So, it
did not take into account expectations in the valuation of companies. The market
price of a stock incorporates the current level of EVA and the expectation of future
EVA growth. To increase the stock price, management must increase the current
level of EVA and change the market’s expectations of future growth. On the other
hand, the estimates of the charge for capital and accounting adjustments may not
be the ones that the market is using to value companies. Furthermore, the market
may not be recognizing the EVA benefits or even considering EVA in the
valuation during the study period.
Because empirical research on the EVA or value-added measurements of hos-
pitality industry is still in its infancy, this study may be useful to both academics

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 Kim / EVA AND TRADITIONAL ACCOUNTING MEASURES 47

and practitioners in understanding how the market value of hospitality firms was
affected by EVA and traditional measurements. An attempt to find appropriate
performance measures, which explain market value, is an ongoing effort for hos-
pitality financial managers and investors. This study has presented results that
show that EVA is a significant predictor of market value with traditional perfor-
mance measures, even if EVA turned out not to be superior to traditional account-
ing measures. Hitherto, no hospitality researcher has extracted and compared the
relative differences and incremental value of EVA and traditional accounting per-
formance measures. So even though the results have limited value, the study
moves us closer to an explanation of EVA both as a potentially important perfor-
mance measure and as an important analytical tool for capital budgeting and hotel
acquisition analysis. As a way of demonstrating to shareholders the firm’s com-
mitment to adding economic value, hospitality companies may soon need to
disclose EVA in their annual report.

LIMITATIONS AND SUGGESTIONS FOR FUTURE RESEARCH

This study is not free of limitations, which may present some potential subjects
for further research. The research is limited in scope for the following reasons.
There are many adjustment items to be considered in computation of NOPAT and
IC, thus the value of EVA can be contingent upon on the researchers’ choice of
items included in the calculation. In addition, most of the models showed low
explanatory power with low R2 values. In other words, the selected independent
variables accounted for only a small portion of the variance of market values.
Another limitation is the selection of the variables used in this study. The vari-
ables used in this research were arbitrarily chosen among those that were used in
other research studies and considered important influences upon market value.
Some other performance measures such as ROI, ROE, ROS, ROA, and EPS could
be used in future studies.
Because the hotel and restaurant companies have different financial structures,
future research studies could divide hotel and restaurant companies into inde-
pendent samples. It would be helpful to analyze and compare EVA efficiency in
the lodging and restaurant sectors of the hospitality industry. Therefore more
meaningful results could be produced. Future research should be undertaken to
discover the other factors that influence stock returns. Another study could focus
on the trends in the correlation of EVA and MVA in the hospitality industry.

NOTE
1. Stern Stewart & Company is a New York–based global consulting firm that special-
izes in measuring internal and external performance through its proprietary EVA® (Eco-
nomic Value Added) framework.

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48 JOURNAL OF HOSPITALITY & TOURISM RESEARCH

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Submitted October 13, 2003

First Revision Submitted May 21, 2004
Final Revision Submitted April 9, 2005
Accepted April 10, 2005
Refereed Anonymously

Woo Gon Kim, Ph.D. (e-mail: [email protected]), is an assistant professor in the School
of Hotel and Restaurant Administration at Oklahoma State University (210 HESW, Still-
water, Oklahoma 74078-6173).

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