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). newlineNext, 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. newlineThe statistical analysis has been conducted by considering the sample data of 69 large-