How to Really Measure Corporate Performance – Part 1: Why Common Approaches Fail - EPS

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Once the easy gains have been had after a major rally, the hard work of financial analysis begins. The question we seek to answer today is – what measure should an analyst use to evaluate a firm’s performance? We will consider the most traditional approaches such as: EPS Growth, ROE, RONA, and IRR. Sadly at the end of the day these approaches and the various branded derivatives from them are the financial equivalent of lipstick on a pig.

The need for a proper approach to measure and evaluate a firm’s performance is widely discussed. Among the key reasons:

1. Determine if management’s actions create shareholder value

2. Benchmark firms against peers and competitors

3. Use historical data to frame the reasonableness of management guidance

4. Use historical performance to assess the reasonableness of the Value Expectations™ embedded in a stock price

In order to achieve these goals, it is important to frame the key goals a proper performance measure should achieve and then evaluate various approaches against those goals. In no particular order, it is important that a corporate performance metric minimally meet the basic criteria:

1. Considers all the cash flow a firm’s investments generate

2. Captures the economic (not accounting) investments a firm has made

3. Does not change for non-economic reasons

4. Does not make unrealistic and naïve assumptions about a firm’s future performance

5. Answers the question whether a company is creating or destroying shareholder value

With those basic criteria in mind let us begin to evaluate EPS Growth, ROE, RONA, and IRR as corporate performance metrics.

EPS Growth – The most common and least useful corporate performance metric

The Applied Finance Group has a saying – “Earnings are necessary but not sufficient to understand value”. Though earnings and eps growth are the media darlings to summarize how well a firm performed in a given period, this is likely a result of poorly educated talking heads that latch onto the ease with which these metrics lead to sound bites. While learning a firm doubled its earnings makes for a juicy TV sound bite or newspaper headline, such news by itself is very often not very informative or useful. The easiest way to understand this, is by asking one question – “What did those earnings cost?”. Specifically, what was the required investment to generate and sustain those earnings and what will be the total cash flow benefits derived from those investments. Here is a simple example:

Company A and B both sell lemonade. Both spent $1000 to build really nice lemonade stands near the highway, and both generate $100 a year in cash earnings. If the risk of these businesses were such that similar investments generate 7% a year, then building the lemonade stands was a very good idea for each owner to pursue. The logic for this is fairly simple – if they invested in a business of similar risk, each owner would have earned $1,000 x 7% = $70. By owning the lemonade stands, the owners of company A and B now earn $100, which exceeds their $70 opportunity cost to tie up their capital in alternative investments. Their investment in lemons was indeed turned into lemonade.

Now assume that company A decides the lemonade business is wonderful, and they can improve the bottom line of both companies through the synergies created by aggressive management. Company A management determines that if they controlled Company B’s assets, they could make the combined earnings of the two companies $250. Company A talks to its owners and tells them, that they can increase their earnings 150%, if they acquire company B for $2500. The promise of 150% earnings growth is too hard to overcome, and the owners readily provide the additional capital to carry out the transaction. At the end of the year, Company A makes a grand announcement that it increased earnings by 140% ($10 of the synergies never materialized) and the TV talking heads repeat the news and interview the CEO who talks about how thrilled he is with the firm’s growth and how well his team executed the transaction, generating an additional 40% earnings growth through synergies. Sadly, the stock sold off months before when the transaction was announced and the market reacted to the TV interview with a yawn. Why?

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Company A has now invested $3500 of capital to generate $240 worth of real cash earnings. This resulted in a combined return of 6.8%, below the 7% opportunity cost of investments with similar risk and well below the 10% generated by Company A on its own before the transaction. Ultimately, company A’s owners created a massive shareholder for the owners of Company B by overpaying for the Company B business. Notice that the former owners of Company B, now have $2500 that they can invest at 7% (similar risk to their lemonade stand) generating $175 on their investment annually compared to the $100 they received while running the business. In this example, Company B’s owners were well served to “take the money and run”, which is a common result in the mergers and acquisition area that is often driven by earnings growth motivations.

For a recent real life example, one has to look no further than the Kraft/Cadbury’s transaction, which is spiritually a giant lemonade stand transaction – given the consumer food oriented focus of each firm. ValueExpectations has written extensively about this deal (here and here) explaining why Kraft owners were being punished in the market each time the likelihood of the deal increased, and conversely why Kraft owners benefited when the deal seemed less likely. This seems like a complete earnings growth, rather than wealth creation oriented transaction.

Ultimately, while earnings growth makes for great headlines, it does not really capture wealth creation as it fails to properly account for the investment required to support such growth. Earnings in a vacuum also fail to properly handle the opportunity cost of making investments, as in the calculation of published earnings figures, there is an implicit assumption that equity capital is free – which is false and an emphasizes why it is so important to fix the gaps in GAAP (Generally Accepted Accounting Standards) to properly measure corporate performance.

The subsequent installments of this series will discuss the pitfalls with ROE (Return on Equity) as a performance metric, RONA (Return on Net Assets), and IRR (Internal Rates of Return) type metrics. The series will conclude with a look at more economic based metrics and discuss why Economic Margin is ultimately the preferred approach to understand and measure a company’s performance.

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