56 Managerial Finance

Net Value Added as An Explanatory Variable for

Returns
by Ahmed Riahi-Belkaoui and Ronald D. Picur

Abstract

This study investigates the usefulness of net value added in explaining stock returns of a
sample of US firms. The results provide evidence that current and past levels of net value
added or current and past levels of changes in net value added are associated with stock
returns. A case may be made for the disclosure of value added information by US firms.

1. Introduction

Value added reporting is presented in the international accounting literature as a viable

alternative and/or a supplement to the conventional income and cash flow statements. It
is an accounting measure of wealth attributable to all of the firm's stakeholders (equity
holders, creditors, employees and governmental taxing units) [Bannister and Riahi-Bel­
kaoui, 1992; Karpik and Belkaoui, 1985; Choi and Mueller, 1992; Gray and Maunders,
1980; Riahi-Belkaoui, 1992; Bao and Bao, 1989]. Its eventual introduction in the US
reporting system has been recommended by the American Accounting Association (AAA)
Committee on Accounting and Auditing Measurement [1991]. Its usefulness is tested in
terms of its relevance for the explanation of security returns. More specifically, we
investigate whether the level of net value added or the changes in net value added divided
by price at the beginning of the stock return period are relevant for evaluating net value
added/returns associations. A book valuation model and a wealth valuation model are used
to motivate the net value added/returns associations.

The results provide evidence that current and past levels of net value added or current
and past changes in net value added are associated with stock returns.

The models relating net value added variables and returns are presented in section 2.
Section 3 describes the data and sample selection. Section 4 presents the empirical
analyses of the issue of whether the level of net value added or the changes in net value
added are better associated with stock returns. Section 6 presents a summary of the results
and some conclusions.

2. The Relations Between Net Value Added and Returns

2.1 Value Added Reporting

The value added statement is generally viewed as a report on the wealth earned by a larger
group of "stakeholders"-all providers of capital, plus employees and government [Meek
and Gray, 1988, p.75]. The net value added is the wealth created by the firm before
distribution to shareholders, bondholders, employees, government and reinvestment. It
can be obtained by the following rearrangement of the income statement:
Volume 20 Number 9 1994 57

S-B=W+I+DP+DD+T+R (1)

or

S-B-DP=W+I+DD+T+R (2)

where

R = Retained Earnings,

S = Sales Revenue,

B = Bought-in material and services,

DP = Depreciation,

W = Wages,

I = Interest,

DD = Dividends, and,

T = Taxes.

Equation (1) expresses the gross value added, while equation (2) expresses the net
value added (NVA). In both equations, the left side (the subtractive side) shows the wealth
created or value added (gross or net), and the right side (the additive side) shows the
distribution of wealth or the disposal of value added among the stakeholders. A great
number of academic writers support the net value added concept for a variety of reasons
(see Gray and Maunders, 1980; Morley, 1978, 1979, and 1981; Rutherford, 1977; and
Meek and Gray, 1992].

2.2 Returns and Net Value Added Associations Based on a Book Value Model

A book valuation model expresses the relationship between price and book value, both
measures of the "stock" value of the shareholders' equity, as follows:

Pjt=BVjt+ujt (3)

where P jt is the price per share of firm j at time t, BVjt is the book value per share of firm
j at time t, and ujt is the difference between P jt and BVjt.

The generation of wealth and the corresponding returns generated, both value
variables, are expressed by the following equation:

∆P jt =∆BV jt +u' jt (4)

58 Managerial Finance

where as defined in equations (3) and (4)

∆BVjt=NVAjt-djt (5)

where djt is dividends paid per share over time period t-1 to t.

Deflating equation (5) by P jt-1 , beginning-of-period price, yields:

R jt =NVA jt /P t-l +u" jt (6)

where

Rjt= (APjt+djt)/Pt-1

Finally assuming that prices reflect information that is included in past time-series
of levels of net value added yields:

Rjt= αt0+ αt1 NVA jt /P t-1 + αt2 NVA jt-1 + αt3 NVA jt-2 /P t-1 + αt4 NVAjt- 3 /P t - l +
αt5 NVA jt-4 /P t-l +E jt (7)

2.3 Returns and Net Value Added Associations Based on a Wealth Model

An alternative model expresses price as a multiple of wealth or net value added. That is:

Pjt= pNVAjt+vjt (8)

If a dividend is paid on security j at time t, equation (5) becomes:

Pjt+djt= pNVAjt+v1jt (9)

Over time, the flow relation yields:

APjt+djt= pANVAjt+v2jt (10)

Deflating equation (10) by P jt-1 , beginning-of-period price yields:

Rjt= p[ANVA jt /P jt-l ]+v 3 jt (11)

Finally assuming that prices reflect information on past time series of changing in net
value added yields:

Rjt= αt0+ α t1 (NVA jt -NVA t-1 )P jt-l +α t2 (NVA jt-1 -NVA jt-2 )/P jt-l
+ α t 3(NVA jt-2 -NVA jt-3 )/P jt-l + αt4(NVAjt-3-NVAjt-4)/Pjt-1
+ α t 5(NVA jt-4 -NVA jt-5 )/P jt-l + E' jt (12)
Volume 20 Number 9 1994 59

3. Data and Sample Selection

The net value added data were computed from COMPUSTAT data items as follows:

Net Value Added (NVA) = The sum of labor expenses, corporate taxes, dividends,
interest expenses, minority shareholders in subsidiaries plus retained earnings.1

The security returns, Rjt, were computed from the Center for Security Price (CRSP)
returns file.

The sample is selected from the period 1982-1991 using the criteria: (i) data needed
for the computation ofNVA are available on the 1991 COMPUSTAT Primary, Secondary,
Tertiary and Full Coverage Annual Industrial File; (ii) security price and the factor to
adjust for stock splits and stock dividends are available on the CRSP file.

The selection procedures resulted in a sample of 5,369 firm-year observations.

Earnings and price variables are adjusted for stock splits and stock dividends.

4. Empirical Analyses

The regression models (7) and (12) are estimated for the pooled cross-section and
time-series sample as well as for each year t of available data. The results from regressions
(7) and (12) are reprinted respectively in Tables 1 and 2. For the regressions using the
pooled sample of all 5,369 firm-year observations, the coefficients are significantly
different from zero at the 0.01 level in most cases. The R2 from the pooled regression
based on the levels model in equation (7) is 21.16% compared to the R2 of 20.12% from
the equivalent regression for the changes model in equation (12).2 For the year-to-year
regressions, the models (7) and (12) were significant in all but one of the 10 cases.
Similarly the R2 from the levels is higher than the R2 from the changes model in all cases
but one.3

The results indicate that a) the level of net value added as well as the changes in net
value added are both relevant for explaining stock returns, and b) the level of net value
added has a better association with stock returns than the changes in net value added.

5. Summary and Conclusions

The results of this study indicate that a) both the levels of net value added and the changes
in net value added deflated by beginning-of-period price play a role in security valuation,
b) both past periods' levels of net value added and changes in net value added possess
significant explanatory power for the current period's stock returns, and c) the net value
added based model has a better association with stock returns (based on R2) than net value
added based changes model.

The results point to the usefulness of net value added as a measure of wealth. The
relevance of the levels of net value added variable suggests its use in the search for a better
understanding of the relations between accounting measured wealth and returns. These
results point to the need for the disclosure of the underlying data needed to calculate value
60 Managerial Finance

added variables. The current US disclosure system does not mandate some of the
information needed to compute the value added. Given the availability of this data, and
therefore the low cost of disclosing it, the US reporting system would improve by the
additional disclosure of value added information.
Volume 20 Number 9 1994 61

Endnotes

1. Each variable is defined using COMPUSTAT's annual individual data as follows:

NVA = [42t+6t+19t+21t+15t+49t+36t-36t-1]

2. Because of possible cross-sectional correlation in the regression error in the equation

of each of the models, there is the potential for bias in statistical inferences regarding the
earnings coefficients (see Bernard, 1987). Accordingly, an alternative procedure is used
to test the significance of the earnings coefficients by using the mean and standard error
of the coefficients obtained from the separate annual regressions (with the assumption
that these annual regressions are independent). These calculations are shown in both Table
1 and 2. All the coefficients are significant indicating that the significance of earnings
coefficients is unlikely to result from potential cross-sectional correlations.

3. To check if the results might be affected by collinearity among the variables, condition
indexes were computed for each regression reported in both tables. As suggested by
Belsley, Kuh and Welsh [1980], mild collinearity exists if the maximum condition is over
30. The results in this study indicate a condition index with a higher value of 4.
Collinearity, therefore, does not seem to affect our results.
62 Managerial Finance

References
American Accounting Association, Committee on Accounting and Auditing Measure­
ment, 1989-90, Accounting Horizons (September 1991), pp.81-105.
Bao, Ben-Hsien and Da-Hsien Bao, "An Empirical Investigation of the Association
between Productivity and Firm Value," Journal of Business Finance and Accounting
(Winter 1989), pp.699-717.
Bannister, J.W. and Ahmed Riahi-Belkaoui, "Value Added and Corporate Control,"
Journal of International Financial Management andAccounting (Autumn 1991), pp.241-
257.
Belsley, D.A., Kuh, E., and R.E. Welsh, Regression Diagnostics: Identifying Influential
Data and Sources of Collinearity (New York: Wiley, 1980).
Bernard, V.L., "Cross-Sectional Dependence and Problems in Inference in Market-Based
Accounting Research," Journal of Accounting Research (Spring 1987), pp.1-48.
Choi, D.S.F., and G.G. Mueller, International Accounting (Englewood Cliffs, NJ: Prentice
Hall, 1992).
Gray, S. and K. Maunders, Value Added Reporting: Uses and Measurement(London: The
Association of Certified Accountants, 1980).
Karpik, P. and Ahmed Belkaoui, "The Relative Relationship Between Systematic Risk
and Value Added Variable," Journal of International Financial Management and Ac-
counting (Autumn 1985), pp.225-45.
Meek, Gary and Sidney J. Gray, "The Impact of Stock Market and Corporate Globalization
on Disclosure Trends in International Financial Reporting" in Changing International
Financial Markets and Their Impact on Accounting (Champain, Ill: Center for Interna­
tional Education and Research in Accounting, 1992), pp.43-66.
Meek, Gary, and Sidney J. Gray, "The Value Added Statement: An Innovation for US
Companies?" Accounting Horizons (June 1988), pp.73-81.
Morley, M.F., "Value Added Reporting". In Development in Financial Reporting, Edited
by Thomas A. Lee (London: Philip Allan, 1981), pp.251-69.
Morley, M.F., "The Value Added Statement: A British Innovation," The Chartered
Accountant Magazine (May 1978), pp.31-34.
Morley, M.F., "The Value Added Statement in Britain," The Accounting Review (July
1979), pp.618-689.
Riahi-Belkaoui, Ahmed, Value Added Reporting (Westport, Ct: Quorum, 1992).
Rutherford, B.A., "Value Added as a Focus of Attention for Financial Reporting: Some
Conceptual Problems," Accounting and Business Research (Summer 1977), pp.215-220.
White, H., "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct
Test for Heteroskedasticity", Econometrica (May 1980), pp.817-38.
Volume 20 Number 9 1994 63

TABLE 1: SIMPLE REGRESSIONS OF ANNUAL SECURITY RETURNS ON CURRENT AND PAST DEFLATED NVA LEVELS

NVA LEVELS. Rjt = αt0 + α t 1 N V A j t / P t - l + α t 2 N V A j t - l / P t - l +αt3NVAjt-2/Pt-l +αt4NVAjt-3/pt-l +αt5NVAjt-4/Pt-l +εjt

PERIOD α t0 αt1 αt2 αt3 αt4 αt5 R2 F N

1982-91 0.1589 0 0081 0.0015 -0.0012 -0.0013 0.0019 21.16% 287.93* 5369
(7.962)* (26.603)* (3.283)* (-2.758)* (-2.575)* (3.92)*

1982 0 2937 0.0016 0.0021 - 0 004 0.00018 -0.0031 22 25% 25.071* 443
(16.33)* (2.417)* (2 833)* (-6.953)* (0.165) (-4 399)*

1983 0.2039 -0 001 -0.0003 -O.0047 -00013 0.0035 9.91% 10 007* 460
(5.612)* (-1.124) (-0.685) (-4.776)* (-1-31) (2.874)*

1984 0.0119 0.0018 0.0001 0 0004 -0.0008 0.0004 2.56% 2.533** 490
(0 915) (1.869)*" (0 426) (1.165) (-0.955) (0 587)

1985 0.4611 0.0008 -0.0017 0 -0.0004 -0.0014 0.40% 0 037 510

(2.77)* (0111) (-0.278) (-0003) (-0.101) (-0.178)

1986 0.0537 0.0037 0.0012 0.0011 -0.0004 0 003 6.15% 6.757* 521
(2.416)* (3.37)* (1 076) (0.973) (-0 619) (3 8)*

1987 -0.1163 0 004 -0.0008 -0.0024 -0.001 0 0004 8 69% 10.39* 551
(-7.304)* (5.936)* (-171)* (-3.555)* (-1.286) (0 832)

1988 0.1455 0.0078 -O.007 - 0 0033 0 0023 - 0 0004 10.50% 68.97* 574
(5.98)* (18 84)* (-10.14)* (-5.704)* (2.425)* (-0 615)

1989 0 1799 0.0004 00001 0 0 0004 00013 1.97% 2.373" 594

(1.263)* (0.918) (0 501) (-0.168) (1228) (2.613)*

1990 -0.1803 0.0008 0 -0 0005 - 0 0003 0.0001 3.54% 4 365* 600

(-15.95)* (3 646)* (-02) (-1.416) (-1.536) (0.367)

1991 0.556 00001 0.0016 - 0 0016 0.0013 0.0004 0.70% 0.864 617
(7 002)* (0 895) (1.127) (1.448) (0.815) (0.386)

MEAN (2) 0.002 -0.00047 -O.0015 -0.0000 0 00042

(3 6878)* (-0.705) (-1.8989)* (-0.1174) (0.6267)

(t statistics are provided in parentheses)

* significant a t α = .0t

(1) THE TEST STATISTICS ARE T-STATISTICS BECAUST THE WHITES TEST FOR HETEROSLEEDASTICITY IN THE RESIDUALS REVEALED
NO SIGNIFICANT HETEROSLEEDASTICITY. WHEN THERE IS (IS NOT) SIGNIFICANT HETEROSLEEDASTICITY, THE TEST STATISTICS
REPORTED FOR THE INTERCEPTS AND THE SLOPES ARE Z-STATISTICS (T-STATISTICS) APPROPRIATE FOR SUCH CASES.

(2) THE IS THE MEAN OF THE YEARLY COEFFICIENTS, ESTIMATED TO TEST FOR THE EFFECT OF CROSS-SECTIONAL CORRELATION
IN THE ERROR TERMS.
64 Managerial Finance

TABLE 2 . SIMPLE REGRESSIONS OF ANNUAL SECURITY RETURNS ON CURRENT AND PAST DEFLATED NVA CHANCES

NVA CHANGES: Rjt = α t 0 +αtl(NVAjt - NVAjt-1)/Pt-l +αt2(NVAjt-1 - NVAjt-2)/Pt-1 +αt3(NVAjt-2 - NVAjt-3)/Pt-l +αt4(NVAjt-3 - NVAjt-4)/pt-1 +
αt5(NVAjt-4 - NVAjt-5)/Pt-1

PERIOD «to αt1 αt2 αt3 αt4 αt5 R2 F N

1982-91 0 1009 0 0078 -0 0057 -0.0026 -0 004 0.0034 20.12% 252.37* 5369
(4 7 8 4 ) * (25.878)* (-16 076)* (-4 369)* (-0 618) (4 927)*

1932 0.2701 0 0015 -0 0007 -0 0003 -0 0049 0 0018 20 02% 25 616* 443
(14 791)* (2.369)* (-0 836) (-0.242) (-2 123)** (0 02)

1983 0 1679 -0 0005 0 0005 -0 0049 0 0089 -0 0079 8.34% 13 708* 460
(7.762)* (-0.563) (0 73) (-4 993)* (4 878)* (-12 777)*

1984 0 0113 0.0018 -0 0017 0 0002 -0 0012 0 0012 234% 2.108** 490
(0 795) (1.834)*** (-1.2907) (0.585) (-1.428) (1 02)

1935 0 4851 00016 -00034 0 0014 -0 0006 -0 0002 0.30% 0 052 510
(2 699)* (0 21) (-0 439) (0.204) (-0141) (0 0237)

193S 0 038 0 0036 -0 0022 -0 0003 -0 0013 0 0036 6 10% 6 102* 521
(1.576) (3 299)* (-1.95)** (-0.204) (-0 814) (3 925)*

1987 -0 1435 0 004 -0 0045 -0 0017 0 0013 0 002 8 19% 11.445* 551
(-8 362)* (6.122)* (-5944)*(-2.036)** (1 4) (1 947)**
1988 0 1454 0 0078 -0 0149 0 0037 0 0057 -0 0028 10 50% 53 86* 574
(5.577)* (18 345)* (-34.231)* (7.171)* (4 648)* (-2.509)*

1989 0 186 0 0007 -0 0006 -0 0003 0 0005 0 0008 1 10% 2 093- 594
(10 617)* (1.209) (-1 071) (-0 413) (1293) (1.26)

1990 -0 1919 0 0009 -0 0013 -0 0004 0 0004 0 0005 3 50% 4 658* 600
(-15 755)* (3 812)* (-2 623)* (-0 963) (1 02) (I 794)

1991 0.5164 0 001 0 0006 -0 0033 0 003 -0 0009 9 69% 0 724 617
(6 629)* (0.763) (0 673) (-1.207)*** 0-547) (-0 467)

MEAN (2) 0 00224 -0 00282 -0 00059 0 0012 -0 00019

(3.74)*(-4 69317)*(-0.2098) (1 028)**(-0 57633)

(t statistics are provided in parentheses)

* significant at α = .01

(1) THE TEST STATISTICS ARE T-STATISTICS BECAUST THE WHITES TEST FOR HETEROSLEEDASTICITY IN THE RESIDUALS REVEALED
NO SIGNIFICANT HETEROSLEEDASTICITY WHEN THERE IS (IS NOT) SIGNIFICANT HETEROSLEEDASTICITY. THE TEST STATISTICS
REPORTED FOR THE INTERCEPTS AND THE SLOPES ARE Z-STATISTICS (T-STATISTICS) APPROPRIATE FOR SUCH CASES.

(2) THE IS THE MEAN OF THE YEARLY COEFFICIENTS, ESTIMATED TO TEST FOR THE EFFECT OF CROSS-SECTIONAL CORRELATION
IN THE ERROR TERMS.