High Economic Margin Buys and Sells

by: Value Expectations

About Economic Margin

Created by The Applied Finance Group, The Economic Margin (EM) Framework was developed to evaluate corporate performance from an economic cash flow perspective and is an alternative to accounting-based valuation metrics. EM measures the return a company earns above or below its cost of capital and provides a more complete view of a company’s underlying economic vitality

Value-based metrics (as opposed to accounting-based methods) have become popular for two reasons. First, capital markets have forced money managers and corporations to have a renewed focus on the balance sheet; these companies are expected to provide an adequate return on the money they have invested. Second, accounting information, although necessary, does not by itself adequately explain market valuations nor provide comparability between firms.

EM is meant to serves two purposes: Create an measure of a company’s economic profitability; that is, 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 this 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. For a more detailed explanation see below.

Economic Margin Calculation

Economic Margin Framework is more than just a performance metric as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital.

Economic Margin captures the relevant drivers that are necessary to evaluating corporate performance and identifies wealth creating firms as well as wealth destroying firms while focusing on the key issues that drive market valuations. The EM also incorporates risk through a capital charge on all of a firm’s cash flow while also providing an annual snapshot to evaluate company track records creating and destroying wealth to evaluate current company actions.

Correcting Common Accounting Distortions

Accounting-based valuation methods provide an incomplete view of a company’s value by not accounting for investment to Generate the Earnings, Cost of Capital, Inflation or Cash Flow. Because the EM corrects these accounting distortions by taking into account 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.

A company’s performance measure must serve as a proxy for its market value creation. Successful corporations consider cash flow, investment, competition & risk when setting strategy with the goal of creating shareholder value. But not all management teams are successful at creating shareholder value. As displayed on the graph below, AFG's Economic Margin can help investment managers clearly distinguish management teams' ability to create shareholder value.

Below is a comparison between Best Buy (NYSE:BBY) and Circuit City (OTC:CCTYQ). Not surprisingly, soon after we took a snapshot of Circuit City’s Wealth Creation report they filed for bankruptcy.

Source (The Applied Finance Group)

Source (The Applied Finance Group)

The average company in the United States generates an Economic Margin of zero. Below is a list of companies that have been able to generate EM's greater than 10% on average over the past three years. Although all of the companies listed have had great success in generating a large spread above their cost of capital, some of these companies are classified as unattractive because they have started to trade at a premium to their intrinsic value and the direction of those Economic Margins is unattractive.

High EM Buys & Sells

Source (The Applied Finance Group)

As discussed earlier, a primary goal of value-based metrics is to eliminate the numerous distortions in accounting data to provide comparability across time, firms and industries. Once we have “cleaned” up the accounting data, we can evaluate if companies are creating or destroying shareholder wealth, and provide more insightful valuations.