Economic Margin, A Link to Market Performance – ConocoPhillips (NYSE:COP)

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AFG’s Wealth Creation Report (below) is a graphical representation of a company’s historical Economic Margin (EM) levels, expected changes in EM levels, Asset Growth, and Relative Market Performance. We have been providing examples of AFG’s Wealth Creation Report on a daily basis so that our readers can see visually that Economic Margins are highly correlated with market values and can provide investors an edge in their stock selection process if they have an understanding of a company’s true economic profitability. Our daily examples will show the wealth creation strategy a company is following as well as that an increase in margins typically leads to market out performance, where a decline in margins leads to market under performance.

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.

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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.

EM is calculated by dividing a company’s Operating Cash Flow minus Capital Charge by their Invested Capital.

It is not uncommon for companies to grow EPS while having declining or negative EM’s. This occurs when the cost for the investment required to yield the EPS (cost of capital) is more than the cash flow generated from the investment. From an economic perspective, this is growing EPS at the expense of the economics of the business.

Unlike traditional measures, EM considers the “profitability” of EPS growth, eliminates accounting distortions, and are comparable across time and industry. By analyzing a company’s EMs through time, investors gain a more accurate account of levels and changes in a company’s current profitability and value.

Economic Margin Framework Helps Investors…

• Eliminate Buy/Sell errors due to Accounting Distortions

• Captures the Relevant Drivers necessary to Evaluate Corporate Performance.

• Allows for the Comparison of Performance across Companies, Industries, and Time.

• Strong, Systematic link to Market Values.

• Identifies Value Creating Firms.

EM Levels and Market Multiples

• EM levels are correlated with market multiples

• EM changes lead to market value changes

To learn more about AFG’s Economic Margin framework...Click Here

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