By Shawn Tully
August 19, 2013

FORTUNE — Forget P/Es. Trailing, forward, westward, or eastward, the venerable price-earnings ratio tells you little more about the value of a company than its marketing budget. Or (ugh!) its “consensus analyst rating.”

The best measure of how companies perform for shareholders is a wonkish tool called Economic Value Added, or EVA. The advantage of EVA is that it corrects the gap, so to speak, in regular GAAP accounting by gauging what’s really important: whether shareholders are getting returns superior to what they’d garner putting their money in another, equally risky stock or index fund.

According to EVA, a company only truly enriches investors when it exceeds the return that the market already expects from similar stocks. When it beats that bogey, it’s truly making money for you. When it falls short, it’s a loser — even if its official earnings numbers look good.

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EVA’s big innovation is imposing a charge for all the capital that companies deploy to generate profits. Under GAAP, an auto or soft drink manufacturer can keep raising earnings per share by piling cash into expensive acquisitions or modestly profitable new plants. Sure, the interest on the debt used for those investments gets lopped off earnings. What’s deceiving is that companies pay no charge for their biggest source of capital: the equity raised from shareholders and invested on their behalf in retained earnings. That’s money you could put somewhere else and earn interest on it. So shareholders should make sure they’re being properly compensated for that investment.

EVA presents the real picture of that shareholder compensation by placing a stiff fee — equal to the prevailing cost-of-capital — on every dollar of equity sitting on the company’s balance sheet. In the EVA mindset, the only true profit is “economic profit,” the cash generated after paying the full capital charge. Generating EVA is like shooting under par, or at least beating your handicap, in golf. It’s a mark of superior performance. And producing big, consistent gains in EVA is the driver and hallmark of great stocks, from Wal-Mart (WMT) to Amazon (AMZN).

The consulting firm Stern Stewart pioneered EVA in the 1990s, winning such devotees as legendary Coca-Cola (KO) chief Roberto Goizueta. Firm co-founder Bennett Stewart now champions EVA as CEO of EVA Dimensions, which sells software and data that companies use to do this rigorous valuation analysis, and produces original equity research for big institutional money managers.

So what does EVA say about the stock market now? Well, it ain’t pretty.

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Since the recovery began in late 2009, according to an exclusive EVA Dimensions analysis done for Fortune, U.S. companies delivered gigantic increases in EVA that took the figure from extremely depressed depths to its highest level in fifteen years.

Two numbers are critical in determining EVA. The first is return on capital. It’s simply the ratio of earnings to total capital. (EVA uses a special definition of earnings that includes capitalizing R&D and restructuring costs.) The more a company can drive sales higher and restrain costs, without deploying loads of new investment, the higher its return on capital. And that’s just what happened in the early part of the recovery. The nation’s return on capital jumped from 7% in late 2009 to almost 10% by the start of 2012 for non-financial companies — a good performance (though honestly, no better than the number reached at the peak of previous cycles).

What really spurred this rise in EVA was the Fed, as it orchestrated the historic decline in interest rates. That campaign, in turn, drove the cost of capital — which includes the special charge for equity — to astoundingly low levels. From mid-2009 to mid-2013, the cost of capital shrunk from 7% to just over 5%. As a result, the “spread” between what companies earned on their capital, and what they paid for that capital expanded to startling highs. Through mid-2013, the spread stood at an extraordinary 4 points, a 15-year high. Multiply the spread times the total capital employed by the company (equity and debt), and you get EVA.

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So the huge spread meant huge economic profit. (That’s good!) And that sumptuous economic profit is the catalyst for the explosion in stock prices that started in early 2009.

But today, both factors are reversing course, with potentially disastrous consequences for investors. Since mid-May, the rate on 10-year Treasury bonds has jumped from 1.6% to 2.8%. That’s lifted the cost of capital by about as much, from a low of 5.2% to around 6.3%. The less-known issue, which EVA Dimensions’ data shows vividly, is that profitability is also dropping sharply. Since 2011, return on capital has fallen to around 8.9% for non-financials, a decline of 1.1 points. It’s as if stocks were caught between two powerful pincers that are now inexorably narrowing.

The sudden fall in the return on capital has two sources, and they’re likely to remain on a downward track. First, companies were extremely successful in lowering costs during both the downturn and the recovery, chiefly through workforce reductions. In 2006, U.S. employers had 3.5 workers for every $1 million in sales. Today, 2.6 workers produce every $1 million in revenues. Corporate overhead has fallen from almost 13% of revenues in the early 2000s to a 15-year low of 11%. “Expenses may remain stable, but it’s clear companies have run out of room to make major cost reductions,” says Robert Corwin of EVA Dimensions.

Second, corporations are suffering a shocking drop in sales growth. Since the second half of 2011, sales growth has gone from chugging at an annual pace of nearly 12% to trudging at a paltry 2.5%. Creeping revenues inevitably lead companies to invest less in their future growth and operations. When companies don’t see folks crowding the stores or showrooms, they curb spending for expansion and improvements. Growing sales and new investment are crucial to boosting EVA, and both sales and investment are expected to remain soft for some time. Capital growth can also boost EVA, but it too is likely to be weak going forward.

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That creates a virtually insurmountable problem. The only way that stock prices can surmount the tide of a rising cost of capital is if the return on capital — the profitability generated mainly from rising sales — rises even faster. By contrast, if the cost of capital keeps going up, and the return on capital continues to tumble (or even stay steady), stock prices are bound to fall.

The sharp fall in interest rates through the first half of 2012 masked the problem. Now it’s fully apparent. “Over the past eighteen months, the EVA of U.S. companies was sustained by the falling cost of capital, not rising profitability,” says Corwin. “The current state of zero profitability increases won’t cut it.”

Investors are hardly naïve. Right now, although PE ratios are high by some measure, the EVA methodology shows that the market is the most pessimistic it has been about growth expectations in the past fifteen years, with the exception of the 2008-2009 crash. The rub is that investors may not be pessimistic enough.

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Just how big is the potential drop? Corwin isn’t making any predictions. But he did provide Fortune with a series of forecasts showing what would happen given various changes in the cost of capital and profitability. Let’s assume that the 10-year Treasury bond returns to a reasonably normal level of 4.5%. That would drive the cost of capital from the current level to around 7%. Even if the return on capital remained steady at the current 8.9%, stock prices would drop by 25%.

It may not happen. Companies could find new ways to enhance their profitability. But don’t bet against EVA.

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