A recent article in the CFO Journal section of the Wall Street Journal highlights the importance of “Economic Profit” as a benchmark for Middle Managers’ bonuses. The article titled “Stock Loses Some Sway on Pay,” from the October 30, 2012 edition (page B4), starts out by stating that “fewer companies are tying their incentive-pay programs directly to their stock price, focusing instead on operating profits and cash-flow measures they say help employees better see their impact on company performance.” The piece goes on to illustrate how companies such as PepsiCo, Clorox, Coca-Cola, Kaiser Aluminum and others all use Economic Profit as an incentive metric. Owners of closely held businesses should take note of this article and topic!
First, the primary goal of business owners is to maximize long-term shareholder wealth. Maximizing wealth is directly tied to maximizing the value of the Firm. The value of the Firm, as Warren Buffet (a fairly successful and well-known business owner!) explains on page 4 of his Owner’s Manual (http://berkshirehathaway.com/ownman.pdf) is “the discounted value of the cash that can be taken out of the business during its remaining life.” Financial theory expresses it mathematically:
Where PV represents the Present Value of the Firm, CF represents free cash flow and r represents the (after-tax) risk adjusted required rate of return.
Economic Profit at a high level is equal to Free Cash Flow (i.e., CF in the formula above) minus the Firm’s Cost of Capital, where the Cost of Capital is equal to the after-tax cost of capital (i.e., r in the formula above) times the total invested capital of the Firm. Notice that Economic Profit uses the exact same financial metrics that are the drivers of the Present Value of the Firm! Notice a few other key points:
- Net Income and EBITDA are not the same thing as Cash Flow.
- If a business owner looks at his/her Income Statement, they will not find the true cost of debt and equity capital reflected as an expense. Economic Profit does incorporate the true cost of debt and equity capital.
- Economic Profit is a superior measure because it is aligned with the goal of shareholder wealth maximization – it uses cash flows and a true risk-adjusted cost of capital in its measurement.
- Economic Profit is not easy to calculate, so it is sometimes not used as a metric. Keep in mind it doesn’t always pay to take the easy road – in life or in finance!
You may be wondering why this is important to you. I know it is a lot to take in, and I have barely scratched the surface of a very complicated subject. With that said, it is too important to ignore — so I will leave you with this thought: I often hear business owners talk about “Profit” and the importance of “being profitable.” But what does “being profitable” really mean? Is your idea of “profitable” in line with your goal of maximizing wealth? If you have positive Net Income or EBITDA, does that always mean you are “profitable?” The answer is no. If your goal is to maximize shareholder wealth, then a better measure of whether you are “profitable” is whether you are generating positive Economic Profit. Thank you to the Wall Street Journal for highlighting this critical yet sometimes ignored concept!
Note that this is one of the many areas where a small Firm can benefit from having a strong Chief Financial Officer, and is an example of the type of value-added approach and critical analysis we provide to our clients at Team13System. If you would like to increase your Firm’s “Profitability,” and/or if you would simply like to learn more about Wealth Maximization and Economic Profit — please call us.