Toronto Star, June 30, 2002
By Madhavi Acharya-Tom Yew
TWO LITTLE words may be coming soon to a company near you: economic profit.
Used as a tool for measuring a company's financial performance, economic profit was first developed 50 years ago but is enjoying a resurgence as North American stock markets and investors try to recover from a high-tech-induced hangover.
The concept, which aims to gauge how efficiently a company puts its capital to use, may become increasingly popular in the wake of the growing list of accounting scandals -- Enron, WorldCom, and Xerox Corp. -- that has market watchers worried that financial reporting is rotten to the core.
Investors and management consultants alike are touting economic profit, also known as economic value added or EVA, as the best way to gauge the overall health of a company.
Fortune magazine calls it "today's hottest financial idea and getting hotter." New York consulting firm Stern & Stewart Co. has even trademarked the term economic value added and focuses its practice on teaching companies how to train their top managers in EVA-based decision-making.
Likewise, a growing number of equity research firms are developing their own rankings of publicly traded companies based on EP numbers.
According to Aman Raina, president of Toronto-based independent equity research firm AKR Capital Research, the Enron/Arthur Andersen scandal "crystallized" the Canadian investment industry's addiction to financial numbers such as earnings per share.
"Given the growing malaise in financial reporting, we feel strongly that measures like EP will become more and more relevant as investors will demand fact rather than fiction," Raina writes on the company's Web site.
Raina adds in an interview: "Unfortunately we've gotten into a situation now where companies are really much more about quantity of earnings rather than quality of earnings. The EVA approach tends to put more emphasis on the company's ability to manage its capital effectively."
High-profile converts to EP in the United States include Coca-Cola Co., Monsanto, Rubbermaid Inc., Sprint, Toys R Us, and the U.S. Postal Service. By some estimates, the economic profit method is already being used by as many as 30 per cent of Canadian companies, including Alcan Aluminium, cable company Cogeco Inc. and Robin Hood Multifoods.
One example is Molson, whose chief executive, Daniel O'Neill, received a whopping $2.4 million bonus for fiscal 2002. The amount was based, in part, on EVA improvement, the company says in its management proxy circular. O'Neill, credited with the highly successful "Joe Canadian" and "Had Ex Today?" television commercials, closed several breweries, laid off hundreds of staff and slashed overhead costs, using the savings to modernize remaining breweries, moves that sent Molson shares soaring.
What lies behind the concept is a simple idea: Capital isn't free.
`We feel strongly that measures like EP will become more and more relevant as investors will demand fact rather than fiction.'
Aman Raina, AKR Capital Research
When a company needs to raise money to buy more equipment or build a new factory, it can sell shares, issue bonds or borrow from the bank. It has to pay dividends on the shares, or pay interest on the bonds and loans.
"Until a business returns a profit that is greater than its cost of capital, it operates at a loss," writes influential management guru Peter Drucker, a firm believer in EVA. "Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources....Until then, it does not create wealth; it destroys it."
The formula for calculating economic profit is posted on many Web sites. Typically, it's expressed this way: economic profit is equal to net income minus a charge for the use of capital (which, in turn, is defined as the company's cost of capital in percentage terms multiplied by the dollar amount of invested capital.)
Here's a simple example: ABC Inc. has a net income of $100,000. Assume invested capital of $20,000. The cost of capital is estimated to be about 10 per cent, or $2,000. So, ABC's economic profit works out to $98,000 ($100,000 minus $2,000). Over at XYZ Ltd., that company's bottom line comes in at $150,000 on the same invested capital. Economic profit is $148,000. It's obvious that XYZ made more efficient use of the same amount of capital.
"If we look at a company that's earning 6 per cent, if they make a statement that, `We're very proud of this because we only made 4 per cent the year before,' economic profit would say, `If money cost you 10 per cent, you're not doing such a good job,'" says John Moore, director of the executive M.B.A. program at Queen's University.
While consultants focus on showing companies how to use economic profit when making decisions on new projects or new markets, investors insist that stock prices of companies making good use of capital will rise accordingly.
According to AKR's Top 100 Wealth Creators, Canadian National Railway Co. generated about $1.4 billion in economic profit last year, topping the annual survey.
CN "has demonstrated a clear ability, despite the slowdown in the economy, to utilize their assets much more effectively than most," Raina says.
CN's stock price seems to bear that out. In January, 2001, the shares were trading in the $47 range but closed last week just below $80, more than fully recovered from a sharp dip in the days after Sept. 11.
Not surprisingly, Nortel Networks comes in dead last in AKR's ranking, after having destroyed $13.16 billion in invested capital.
Nortel used to be one of the biggest wealth creators, Raina says, but that was back when the bull market for telecommunications equipment was still in full stampede. Economic profit calculations show that as the market slowed, the company's operating profits were growing at a slower rate than the amount of capital that was being invested.
"In the last couple of years, they've been in such an expansion mode, buying companies and basically allocating capital to ideas and companies that were not generating wealth," Raina says.
`Certainly, I think people were making investment decisions based on hopes and dreams rather than what the number were really saying.'
John Moore, Queen's University
Throughout the history of performance evaluation, the only figure people were concerned about was the bottom line -- profit. Then, in the early 1900s, businesses started to realize it was better to consider net income relative to the initial investment. Return on investment, or ROI, was born.
That became the prevailing thinking for the next 50 years. ROI, however, didn't take into account the cost of capital. That's where economic profit -- then known as residual income -- came in. It was used by some 30 per cent of the Fortune 500 companies before it fell out of favour. >
"One of the main reasons why companies dropped residual income was that they felt their managers did not understand it," Moore says. "So, better the devil you know than the devil you don't know."
But it was the high-tech boom that really put performance measuring on its ear. As the experts proclaimed that Internet firms simply couldn't be judged by the same old criteria, like net income or return on investment, financial analysts began to focus on everything from Web page visits to EBITDA (earnings before interest, taxes, depreciation and amortization).
"There's no question that the market lost sight of the basic fundamentals on how to evaluate performance," Moore says. "Certainly, I think people were making investment decisions based on hopes and dreams rather than what the number were really saying."
There's nothing wrong with looking at EBITDA figures, he adds "but you shouldn't make investment decisions based on that because you're almost saying that interest, taxes, depreciation and amortization are things that are not important. For a lot of companies, they were very big numbers."
From an investment perspective, economic profit has its shortcomings. Its complexity makes it difficult for the average investor to use, especially when compared with far simpler price-earnings ratios. Nor does it take into account cash flow, another critical component of a healthy business.
Some observers suggest that the latest market turmoil will spur investors to put a greater emphasis on the basic concepts of revenue and net income, rather than other numbers. "People really just want to know what's the bottom line, especially in this kind of market," says Irwin Michael, portfolio manager with ABC Funds.
From a management perspective, economic profit tends to favour larger companies that have more capital to invest in the first place. It can also be difficult to engage employees who are not involved in front-line investment decisions. Nor should it be used in isolation, Moore says. "The best-managed companies tend to look at both economic profit and return on investment."
Today's office technology and much-improved accounting systems may also give EP a boost. During the heyday of residual income, the accountant's tools consisted of a pencil and 20-column green paper. Work on the annual budget began in July and, with any luck, was completed in December. When somebody at head office changed a number, the accountant had to start all over again. Now, internal financial reporting can be produced within two or three weeks of the end of a quarter.
"Before computers, a lot of these things couldn't be calculated because of computational complexity," Moore says. "Now, it is time-consuming to set up the system to produce the report but once you have it set up, it's just a matter of punching a button and out come the reports."
That's not to say that economic profit is the end of the road in performance metrics. Experts say there's also another valuation method on the horizon.
Cash value added, a term trademarked by two Swedish professors, is very similar to economic profit, but provides a more comprehensive picture of a company's cash flow. Queen's has included the concept in its M.B.A. programs for the last three years.
Copyright 2002, TorStar Publications