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September 18, 2019

Economic Margin – Removing Market Noise

A corporate performance metric should provide insights into what a firm is worth. Most money managers utilize common earnings-based measures of corporate performance and value, which are suspect and easy to manipulate. Applied Finance developed the Economic Margin (EM) framework to remove the noise inherent in accounting data.

While there are countless firms relying on rudimentary “Value” metrics, only Applied Finance has a 20 year live database, providing unique and actionable insights into the underlying economic vitality and intrinsic values of over 20,000 companies.

Traditional accounting-based valuation methods provide an incomplete view of a company’s value by not accounting for the investment needed to generate the earnings, cost of capital, inflation or cash flow.

Exhibit 1: Most investors assume that higher earnings growth rates correspond to higher P/E multiples.  However, regardless of how well a firm performs as measured by earnings growth, the market appears indifferent to such growth in assigning a firm’s P/E.

Our proprietary Economic Margin goes beyond the limitations of earnings based approaches and evaluates corporate performance from an economic cash flow perspective. We effectively link the income statement and balance sheet to capture differences in:

  • Capital Structure
  • Asset Age
  • Asset Life
  • Asset Mix
  • Off Balance Sheet Assets
  • Liabilities

In short, we strive to measure investment needed to generate earnings and cost of capital.

EM is meant to serve two purposes: Create a measure of a company’s profitability which answers; did this company generate cash flow in excess of the costs of its capital invested in its operations, or did the company destroy wealth? Once we have solved for this, we can then use EM as a function in our valuation model.

EM is calculated by dividing a company’s operating cash flow minus capital charge by their invested capital.

AFG’s Economic Margin evaluates corporate performance by addressing three primary questions:

What is the firm’s cash flow?

• Net Income does not accurately reflect the true cash flow of the firm due to accrual accounting.

How much capital is required?  

• Inflation distorts historical book value comparisons between peers that capitalize at different times, as well as an understanding of the real value of a firm’s balance sheet assets today.

• Research & Development costs, which are long term investments for future cash flows, are immediately expensed under GAAP accounting.

• Operating Leases, obligations which must be paid similar to debt, never appear on company balance sheets.

We ultimately want to identify the real value of all invested capital employed by a company instead of simply focusing on historical book value.

What are the opportunity costs of capital?

• Cash Flow vs. Cost of Capital can help better explain economic profitability.

• Different asset characteristics (life & age) distort comparisons between capital investments and DD&A.

• Cost of capital defined by size and leverage characteristics more accurately reflect the riskiness of a firm than a beta-driven estimate.

Exhibit 2: Because EM corrects accounting distortions  by taking into account a company’s: Risk,  Asset Life, Asset Mix, Asset Age, Capital Structure and Growth, effectively linking the income statement and balance sheet, EM levels have a much higher correlation with market Values.

By evaluating corporate performance for each company in the FTSE World Index from an EM perspective, we can clearly see that the market is willing to pay a higher multiple for companies that are generating higher EM’s.

Successful corporations consider cash flow, investment, competition & risk when setting strategy with the goal of creating shareholder value. Not all management teams, however, are successful at creating shareholder value.

Our analysts and portfolio managers are able to distinguish management teams ability to create shareholder value in a consistent, clear, and objective approach.  They can see how companies are deploying their capital and whether they should trade at premiums or discounts to their book value.  For example,  as shown in the chart below, since 2001 GE’s Economic Margins have been on a steady decline, despite increases in accounting earnings over much of this period.  Consistent with this insight, it is no surprise GE has dramatically underperformed the market through 2018.

Data Source: Applied Finance Equity Insights Database 2018