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Stocks: Consistent Profitability = Consistent Returns
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 strength.
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 a 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.
Understanding a company’s Economic Margin levels and expected changes in EM levels can provide investors an advantage in the market as AFG has proven through backtests and company examples that a company’s EMs are highly correlated to its market performance. Companies who are able to generate positive EMs and grow their business are following what AFG considers a “wealth-creating” strategy.
Companies that earn consistent positive EMs tend to attract competition which tends to erode a company’s profits and reduces the firm’s high-margin growth opportunities. A key difference between AFG’s valuation model and other DCF models is the assumption that a company will generate profits into perpetuity. AFG assumes that eventually a company’s profits will be competed away to zero over a company specific time period based on the company’s competitive advantages. The rate at which a company’s profits are decayed away depend on many factors including how profitable the firm is, how large the firm is and which direction the companies EM’s have been heading. The chart below illustrates our theory of EM decay and what factor determine how rapidly EMs are decayed away.
Being that profitability attracts competition, we thought it would be interesting to highlight some companies in the S&P 500 that have been able to generate positive EMs for the last 7 years and are expected to increase their EMs in the next fiscal year. It is no surprise that all of these firms have been able to outpace the overall S&P 500 index over the last 7 years as the consistent EMs these firms have experienced have also translated to consistent returns. Not only have these firms been able to maintain their profitability and stave off competition but also look attractive from a valuation perspective.
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 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.
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