An analysis : economic value added and share price movement

Abstract

Value-based management was developed to determine whether companies, through management actions, can create value for their shareholders. Value is created when capital is invested at returns higher than the cost for that capital. The concept of creating value for shareholders has its origins in 1776, when Adam Smith wrote in his An inquiry into the Nature and Causes of the Wealth of Nations, that investors require a return on capital. Since value-based management has appeared in the 1980s, various consulting firms have developed and popularised metrics that can assist management in measuring economic profit. One of the most popular metrics developed was Economic Value Added (EVA) by Stern and Stewart. While value-based management is used to increase shareholder value, one of its serious drawbacks is its short-term focus on immediate results to the detriment of long-term sustainable competitive advantage. The main goal of this study is to investigate and determine whether investors can use economic profit as an indicator for share price movement of non-mining and non-financial South African companies listed on the Johannesburg Securities Exchange. This was done through multiple regression models, in order to determine whether investors can use value-based management measurement to predict share price movement. Value-based measurements selected were Economic Value Added (EVA), Return On Capital Employed, and Return On Equity. Income statement, balance sheet, cash flow statement items, as well as Earnings Per Share were also selected as independent variables in the multiple regression models. The results from this study indicate that the only real measure that can be used for predicting share price movement is Earnings Per Share (EPS). EVA is good for determining shareholder value, but not adequate for determining stock performance. Even though it was found that investors should only use EPS for predicting share prices, companies should still focus on creating value for their shareholders. It is beneficial to investors to understand what value-based management is, and to understand management actions in terms of value creation. South Africa has seen over 30 consecutive quarters of economic growth, which was found in this study to have a good correlation with company performance - not only in terms of EPS, but also in terms of EVA.