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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 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 invesmtent managers clearly distighigh managment teams abilty to create shareholder value.

 

Below is a comparison between Best Buy (BBY) and Circuit City (CC). 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. (Receive Our Stock Reserch Alerts by email)

High EM Buys & Sells

Source (The Applied Finance Group)

 Next week we will be discussing the use of an Economic Margin as a complete valuation system.

Traditional Discounted Cash Flow (DCF) models have been been underutilized in equity analysis over the years primarily because of the assumptions one has to sign off on. We will concentrate on just two of the major issues we have with traditional DCF models, the lack of ability to deal with competition and the perpetuity assumption embedded in a DCF model. These assumptions lead to irrational calculations of intrinsic value and force analysts to make compromising decisions in their model building efforts.

AFG uses a modified DCF model that accurately addresses the competitive nature of the business while also dealing with the perpetuity issue through our Economic Margin decay or competitive advantage period.

The four factors that affect AFG’s Competitive Advantage Period (CAP) are;

Profitability – High Profit leads to increased competition and a higher decay rate
Variability – Higher volatility leads to less predictability and a higher decay rate
Trend – AFG gives the benefit of the doubt to an upward trend which leads to a lower decay rate
Invested Capital – Large Invested Capital creates barriers to entry and leads to lower decay rate

The Decay Rate is the rate at which the Economic Margins™ will diminish over time due to competition, market conditions and limited investment opportunities. Higher decay rates translate into shorter competitive advantage periods, while lower decay rates translate into longer competitive advantage periods.

The Decay Rate profile is downward sloping to the right, which means that Economic Margins™ over time diminish to zero. This does not mean that the company will not have earnings, but instead the company will have an Economic Margin™ of zero, which indicates there are no excess profits after the investors are paid and the depreciating assets are replaced.When selecting securities, companies that are maintaining a high level of economic profitability or growing their profits rapidly are attractive from an investment standpoint. However, the more profitable a firm is the more likely other companies will attempt compete away excess returns.

To illustrate this, one has to look no further than Dell Computer. Dell Computer had Economic Margins™ hovering around 40% (top 5% of all companies) in 1997 and 1998, but soon every major firm was announcing that they were going to build computers to order. Why? Because they saw the huge profits that Dell was making. The result is that Dell's Economic Margin™ for 1999 was around 25%, a decline of 37.5% in just one year. The remaining factors are relatively straight-forward, in that volatile returns are worth less than consistent returns, companies with an increasing Economic Margins™ are worth more than a company in decline, and large companies have a natural barrier to entry, thus a lower decay rate.

Theory: Excess return gets competed away

Fact: In 1997, the median top decile Economic Margin (EM) firm = 17.4%. 10 years later, that same group of companies had a median EM of 6.5%. On the other hand, the bottom decile had an EM of -12.2%, 10 years later that same group had a median EM of -1.0%.

Current Top Decile Economic Margin Companies (S&P 500 ex. financials)

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Here are the 10 best and 10 worst performing stocks in the S&P 500 for the month of May excluding financials. We have provided the returns achieved by each firm during the month of May (5-1-09 to 5-28-09) along with a look at the valuation attractiveness of each of these firms going forward.

May Biggest Movers In S&P 500 (Ex. Financials)

AFG's default valuation is a great place to start when looking for potential equity investments as our valuation techniques have proven successful through time at identifying mispriced securities and helping our clients identify investment opportunities resulting in outperforming their chosen benchmark.

AFG's Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

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Bloomberg provides a score for companies within the S&P 500 based on an average of all analyst ratings from the street. Below is a table highlighting companies with the best analyst ratings, largest increase in rating, highest price targets, and worst analyst ratings and the valuation attractiveness of each of these companies based on The Applied Finance Group’s (AFG) valuation model.

Companies within each of these groups are ranked from most attractive from a valuation perspective to the least attractive. VE.com will actively track the performance of these recommendations and see how they stack up to the analyst recommendations in each group. AFGview.com, AFG’s professional investor website allows you to compare any company using their rating versus the consensus ratings of the sell side. If you are interested in an analysis on a specific company, contact afgsales@afgltd.com.

Best/Worst Analyst Rated Companies (Bloomberg)

AFG's Valuation Model – Using AFG’s modified discounted cash flow model to measure the intrinsic value of a firm compared to its peers. AFG's Value Score - A score which represents the ranked percent to target (deviation between stock’s current trading price and AFG’s current default target price) or attractiveness (upside) relative to the universe. A Value Score of 100 is the most undervalued and 0 is the most overvalued company in the universe.

Economic Margin is a measure of economic profitability that identifies how much a company earns above or below its cost of capital. We analyzed all companies in the S&P500 Index based on their historical, current and forecasted Economic Margins to see which firms have the best average of past, present and future profitability. We identified the two most profitable and the two least profitable companies from each sector and have presented them in the table below. As a base of reference, the average firm in corporate America earns a 0 (zero) Economic Margin, or is a “break-even business”. Our research has shown that companies with consistently positive EMs that are also expected to increase their EMs in the future tend to outperfom firms with negative or declining EMs.
<!--[if gte mso 10]> Economic Margin is a corporate performance measure, which helps us identify well managed, wealth creating companies. Although not included in this post, we want to remind you that it is also important to understand the attractiveness of corporations' valuations to make sure we invest in great companies at great prices. (Here is an article by ValueExpectations.com explaining Applied Finance Group’s basic valuation concepts).

Note: Only companies in the S&P 500 were included.

S&P 500 Companies With The Best/Worst Average Profitability (Economic Margin)

Economic Margin (EM) Defined: A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The 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. more EM details (PDF)

Economic Margin (EM) Defined - A measure of corporate performance that captures off balance sheet items, by looking at how much a company is earning above or below their cost of capital. EM is expressed in a % or margin. The 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.

Here is a list of companies within the S&P 500 that have earned extraordinary Economic Margins (EM) over the last 7 years and are also expected to maintain high levels of EMs over the next two years. Companies expected to improve their EMs more than their peers have proven to be more likely to out-perform. High EM companies on the list below that have low expectations priced-in for sales growth and attractive valuations, are ones that may be worth a look as a potential investment.

S&P 500 Companies That Maintain High Economic Margins

*AFG’s Value Expectation allows us to understand the imbedded Sales Growth, EBITDA Margins, and Asset Turnovers a company has to deliver in the future to justify its current trading price. In theory and in normal circumstances, if the imbedded future performance is very conservative relative to the company’s historical performance, the stock is regarded as undervalued. The table displays the implied future sales growth of companies assuming their EBITDA margins and Asset turnovers stay at the 5 year median levels.

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According to Bespoke.com these S&P 500 stocks over $5 a share, are those that make the biggest advances/declines the day after reporting earnings since this bear market began in October 07’. Included in this table is the percentage of time these companies beat earnings and their average change on report day, along with their implied sales growth expectations. The implied sales growth measures what a company needs to grow sales at over the next 5 years to justify their current price. Comparing those expectations (VE Sales Growth) with what the company has delivered the past 5 years (5 year median sales growth) is a good way to tell if the current expectations are realistic for the company to meet or exceed. The lower the expectations relative to delivered sales growth, the more likely the company is to out-perform.