The individuals entrusted with the management of any company have numerous responsibilities, including providing returns to their capital shareholders and the monitoring and control of performance across divisions, and across the company as a whole. Management thus requires performance measures that allow for the assessment of performance across the company, and which at the same time are indicative of shareholder value added. Economic margin is a performance measure that meets both of these criteria and has many advantages over other commonly used performance measures. These measures are discussed below.
Traditional performance measures
In itself, accounting earnings as a performance measure are insufficient. It is only meaningful in relation to the actual capital investment required to produce the earnings and the true cost of the capital investment. Moreover, these earnings are not directly comparable between companies or between divisions due to the relative size of each company/division.
Metrics such as return on investment (ROI) attempt to improve upon earnings by providing comparability and incorporating the capital base. ROI is one of the most commonly used and sited ratios for performance measurement, and was arguably pioneered by the Du Pont Company in the early 20th century 1. ROI is calculated as net profit before interest and taxation divided by total assets. ROI can be further refined to return on invested capital (ROIC). ROIC is favoured amongst industry analysts, as it removes the distortionary effect of how a company is financed. ROIC can be calculated as net profit after tax plus interest expense less the interest tax shield divided by total assets less cash less non-interest bearing current liabilities. Both ROI and ROIC do not address the inconsistencies between companies and divisions that arise out of different asset lives and asset mixes that are included in the capital asset base. These inconsistencies may lead to disincentives to grow, as ROI and ROIC improve as the capital base is depreciated. This is commonly referred to as the “old plant trap”. Additionally, the mix between leased and owned assets results in distortions in ROI and ROIC across different companies.
Economic performance measures
Neither accounting earnings nor ROI/ROIC include the true cost of capital required to produce the return. Thus economic profit-based metrics have become increasingly accepted and well-used by the world’s top companies and analysts. These measures such as Economic Value Added (EVA) and Cash Flow Return on Investment (CFROI) attempt to remove accounting distortions and, through explicitly including the cost of capital, provide an economic measure of corporate performance and a proxy of the external market-based valuation placed on a company. EVA is a currency unit based measure that reflects the value-added during a period after making adjustments for various accounting amounts and for the cost of capital. EVA is a registered trademark by its developer, Stern, Stewart and Company. Due to the fact that EVA is an absolute number it is, however, difficult to compare across companies and divisions, and similar to ROI/ROIC, does not address the inconsistencies arising out of the different asset lives and asset mixes that are included in the cost of capital asset base. CFROI was developed by HOLT Value Associates and is effectively an internal rate of return that may then be compared directly to the cost of capital. It is thus comparable across companies, however, it is affected by company leverage. Additionally, it is subject to the various limitations of an internal rate of return2.
Economic margin as a performance measurement tool
Economic MarginTM (EM) is an economic profit measure that was developed by the Applied Finance Group 3. EM is calculated as operations based cash flow less the capital charge (cost of capital), all divided by invested capital (refer to Figure A).
The salient features of the EM metric are thus the following:
- That it is unaffected by company leverage and rather is an economic profit measure that includes the cost of capital.
- That it removes various accounting distortions.
- That it is a single figure in a percentage that is comparable over time and between companies and divisions within companies.
- That it explicitly addresses asset economics by adjusting for asset age and inflation, thus removing “old plant trap” distortions and the associated disincentive for growth.
Economic margin: An example
Assume Company A is formed by purchasing R700 000 worth of property, plant and equipment and R300 000 net working capital. The total invested capital is thus R1 000 000 and is financed via R500 000 of shareholders’ equity and a R500 000 loan with fixed interest payments of 10% p.a. The property, plant and equipment have a useful life of 10 years. Company A earns revenue of R1 500 000 p.a., and incurs operating expenses of R1 200 000 p.a. The company’s WACC is calculated as 15% and all net income after tax is declared and paid to shareholders as a dividend. Over a 10 year period, earnings and ROIC as performance measures are illustrated in Figure B.
Note A: ROI has been calculated as NIAT plus interest expense net of tax shield by invested capital
Earnings (NIAT) in themselves are not necessarily a good performance measure because they ignore the invested capital base required to produce such earnings. ROIC includes the invested capital base, however, as can be seen, ROIC steadily increases over the 10 year period as the asset base is depreciated. Additionally, neither measure includes the true cost of the capital required to earn the return.
EVA is reflected in Figure C. EVA may reflect the true value added during each period however, as with earnings, it is difficult to compare EVA across different companies. Additionally EVA increases as the asset base gets older. See Figures C & D.
Note B: EVA has been calculated as NIAT plus interest expense net of tax shield less capital charge (WACC multiplied by the invested capital)
Note C: Net operating cash flow is calculated as NIAT plus depreciation plus interest expense net of the tax shield
As can be seen from Figure D, EM provides a performance measure that takes into account the true cost of capital required to produce the return and is comparable across different companies and divisions within a company. The fact that explicit adjustments are made for asset economics of age, owned/leased mix and inflation, removes the “old plant trap” distortions and the associated disincentive for growth and enhances comparability. Note that no inflationary adjustments are made in this example, however in short this would involve inflation adjusting the asset base to match the inflationary effects on revenue, costs and working capital. It may be noted from this analysis that EM is inherently complicated to calculate in comparison to the other aforementioned performance measures.
It is contended that EM provides a superior measure which in theory provides both; corporate executives with a measure that can be used to monitor and manage performance across divisions with strong links to the investor community’s needs and; investors and company analysts with a measure that is comparable across companies and has strong links to company valuations.
- Brignall, T. J. Stan. 2007. ‘A financial perspective of performance management’. Irish Accounting Review, Summer2007, Vol. 14 Issue 1, pp15-29.
- The inherent limitations of an internal rate of return (IRR) are well documented and include the fact that the use of an IRR may incentivise managers not to accept a new project that is in the interest of the organisation if the project decreases overall IRR, that multiple IRRs may occur and that there is an assumption that arising cash flows are reinvested and earn a return equal to the IRR, which may not hold.
- Orycki, D.J. Resendes, R. ‘Economic Margin: The link between EVA and CFROI’
Chris Nicholson CA(SA), BCom(Hons), is a senior consultant at FutureWorld, which is the strategy and innovation division of Deloitte Consulting.