Market Efficiency, CAPM, and Value-Relevance of Earnings and EVA: A Reply to the Comment by Professor Paulo

Abstract

Dr. Stanley Paulo makes two points or critiques in his Comment on our paper, Operating Income, Residual Income and EVA: Which Metric is More Value Relevant? published in the spring 2001 issue of the Journal of Managerial Issues (Chen and Dodd, 2001). First, EVA is useless because it is conceptually faulty either in an efficient or a non-efficient market. Second, there is growing evidence that accounting information such as earnings and dividends is becoming progressively less useful for stock valuation. Throughout the comment, he cites several published studies, primarily from the behavioral finance literature, to argue that stock price is not driven by intrinsic value, but by factors such as volatility, momentum, and financial herding. While an explicit statement is not made in the Comment, the tenor of the Comment clearly suggests that the author questions the value of capital markets research in accounting. The Comment raises some very important questions given that market-based accounting research has been a primary paradigm of financial accounting research over the past three decades. However, we believe that some of his concerns need to be clarified and others discussed in a more balanced fashion. Consequently, in this Reply, we will attempt to clarify the issues that are specific to our article. We will also discuss evidence contradictory to the Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM), plus the resulting implications for market-based accounting research. EVA, Market Efficiency, and CAPM Dr. Paulo states that EVA is a financial fiction in an EMH world because there could be no consistently abnormal profits due to arbitrage and competitive action. We believe that this comment confuses the EMH and the concept of economic rents or profits. According to the EMH, a market is efficient with respect to a particular set of information if it is impossible to make profits by trading on this set of information. The mechanism to make markets efficient is arbitrage and competitive action by sophisticated investors. However, the EMH does not prevent firms from earning economic rents, defined as profits that cover the opportunity cost of capital, which is a concept identical to EVA. When an industry settles into a long-term competitive equilibrium, all assets are expected to earn their opportunity cost of capital because any economic profits have already been driven away by competition in the industry in terms of expansion by existing firms or entrance by new firms. However, the Long-term equilibrium is not a static point, but rather it is a dynamic process in which the equilibrium is constantly changing. In this process, firms enjoy economic profits due to either industry characteristics, such as industry concentration and industry-level barrier to entry, or firm characteristics, such as monopoly power and competitive advantages. It is because of economic profits that we advocate the use of the discounted cash flow analysis in capital budgeting to look for projects with positive net present values (Brealey and Myers, 2000). Thus, the existence of economic profits does not contradict the EMH as long as stock price fully reflects fundamental information about a firm's earnings generating ability such that at a particular time an investor cannot earn an abnormal return from a stock investment (Kothari, 2001). Dr. Paulo also criticizes EVA as a deficient construct in a non-EMH world because the CAPM is not a valid model for computing expected returns, and stock prices are driven by non-fundamental factors other than earnings or dividends. We would like to make four observations. First, we do not believe that the CAPM is derived from the EMH and is dependent upon the existence and functioning of the EMH; our belief differs from a statement made in the Comment. The CAPM only assumes efficient portfolios; it is not the same concept as the EMH. …