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™ framework to remove the noise inherent in accounting data. 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.
Earnings are a poor proxy for Economic Profitability
• They do not accurately reflect true cash flow of a firm
• Cash flow vs Cost of Capital can help better explain Economic profitability
Accounting ratios mix/confuse many different value drivers
• Traditional measures are based on accounting convention, not cash flow
• Different asset life, asset mix, asset age, capital structure distorts these ratios across firms
• Inflation distorts how reported accounting numbers relate to cash flows received by investors
• Traditional ratios do not account for risk, or the opportunity cost of capital required to generate returns
Accounting rules distort many aspects of economic reality
• Research and Development costs, which are long term investments, are immediately expensed under GAAP accounting
• Operating Leases, obligations which must be paid similar to debt never appear on the company balance sheets
• Inventory Policies and goodwill can also create distortions
