The Search for the Best Financial Performance Measure Jeffrey M. Bacidore, John A. Boquist, Todd T. Milbourn, and Anjan V. Thakor Refined economic value added (REVA) provides an analytical framaoork for evaluating operating performance measures in the context of slmreholder value creation. Economic value added (EVA) performs quite well in terms of its correlation with shareholder value creation, but REVA is a theoretically superior measure for assessing whether a firm's operating performance is adequate from the standpoint of compensating the firm's financiers for the risk to their capital. In this article, comprehensive statistical analysis of both REVA and EVA is used to estimate their correlatio)! with and their ability to predict shareholder value creation. REVA statistically outperforms EVA in this regard. Moreover, the realized retums for the 1988-92 period for the top 25 REVA firms were higher than the realized returns for the top 25 EVA firms. I n the 1980s, shareholder activism reached unprecedented levels and led to increased pres- sure on firms to maximize shareholder value con- sistently. For example. Time n:\agazine summarized this activism as "Angry investors closed out the Decade of Greed with demands that executive com- pensation should be tied to company performance" (Smolowe 1996). The basic idea is that if managers are offered compensation contracts that are tied to shareholder wealth changes, their incentives will be better aligned with those of shareholders than is the case for other types of contracts. In designing such contracts, however, an important issue is which measure of shareholder performance to use in designing the contract. Tlie obvious metric for judging firm perfor- mance is the stock price itself (see, e.g., Jensen and Murphy 1990 and Miiboum 1996). Stock price, how- ever (or returns based on stock price), may not be an efficient contracting parameter because it is driven by many factors beyond the control of the firm's executives. Moreover, as one moves down the orga- nizational ranks, the inefficiencies of stock-based compensation as a means of aligning managerial interests with those of stockholders become even more evident because managers at lower levels have Jeffiey M. Bacidore is a doctoral candidate in finance at Indiana University. John A. Boquist is the Edward E. Edwards Professor of Finance at Indiana University. Todd T. Milbourn is an assistant professor of finance at London Business School. Anjan V. Thakor is the Edward ]. Prey Professor of Banking and Finance at the University of Michigan. even less impact on the stock price than the CEO. Tying managerial compensation to stock price may impose excessive risk on managers and may detract from the ability of such compensation to provide incentive for managers to maximize shareholder wealth. Any financial performance measure used in managerial compensation, on the one hand, must be correlated highly with changes in shareholder wealth and, on the other, should not be subject to all of the randomness and "noise" inherent in a firm's stock price. This dichotomy is the fundamen- tal tension a good performance measure must resolve. A recent example of a performance mea- sure that seeks to resolve this tension is economic value added (EVA). This measure, proposed by Stern Stewart Management Services, creatively links the firm's accounting data to its stock market performance (Stewart 1991). Before examining the correlation between shareholder wealth and a performance measure, one must first define the appropriate way to mea- sure changes in shareholder wealth. We contend that shareholders are concerned with the abnormal return they earn in any period—that is, the return they eam in excess of what they expected to earn for a firm within a given systematic risk class. Wlien this return is positive, shareholders have more than covered their risk-adjusted opportunity cost of pro- viding their capital. Conversely, when this return is negative, they have been inadequately compen- sated for risk." Given this relationship, a good financial performance measure should correlate highly with abnormal stock returns. Financial Anaiysts Journai • May/June 1997 11