{"id":2320,"date":"2010-12-31T11:21:43","date_gmt":"2010-12-31T16:21:43","guid":{"rendered":"http:\/\/www.credittrends.com\/blog\/?p=2320"},"modified":"2010-12-31T16:52:55","modified_gmt":"2010-12-31T21:52:55","slug":"slowing-economic-growth-means-greater-focus-on-economic-profit","status":"publish","type":"post","link":"https:\/\/www.credittrends.com\/blog\/2010\/12\/31\/slowing-economic-growth-means-greater-focus-on-economic-profit\/","title":{"rendered":"Slowing Economic Growth Means Greater Focus on Economic Profit"},"content":{"rendered":"

As I have long pointed out, firms which can add to their capital base projects that are value adding (have a return on invested capital (ROIC) greater than cost of capital, with a good margin of safety), will reward shareholders. But what happens when firms cut back their own such spending or have the ability to piggyback others\u2019 capital or resources, such as R&D or support functions?<\/p>\n

As the current period of slow economic growth continues, firms may continue to ration their capital base, seeking creative means toward higher free cash flows. Included will be using \u201cothers\u201d capital as well as the time-honored low cost producing outlets.<\/p>\n

Companies can, especially as the trend to low-cost manufacturing countries evolves, be expected to continue to reduce their property, plant and equipment (PPE) relative to revenues, with a resultant increase in balance sheet cash, short-term investments, and expansion opportunities. Certainly, Apple Computer (AAPL<\/a>) has been a leading company in this regard, and in the process has been generating very high amounts of excess cash. Investors are, in Apple\u2019s case, ignoring the very low returns on its cash in their valuation of the company, focusing instead on its high economic profit.<\/p>\n

As industrial efficiencies evolve, improvements in technology take place, and management consultants develop techniques to enhance supply and production methods, productivity improves and the growth rate of productive capital falls. This need for less capital intensity positively affects return on invested capital, cash required and financial ratios.\u00a0 McKinsey & Co. found the median level of invested capital for U.S. industrial entities dropped from around 50% of revenues in the early 1970s to just above 30% in 2004.[1]<\/sup><\/a><\/p>\n

What McKinsey found in 2005 has only picked up momentum since. Worldwide competition for sales and market share, especially as economic growth has slowed, has led to additional expense skimming and creative means to reduce or minimize the capital base given a projected revenue stream.<\/p>\n

For certain industries, which have a naturally low capital base, such as service-oriented entities, return on invested capital will be naturally high. And for manufacturing entities which effectively utilize outsourcing or other entity\u2019s capital for a substantial part of assembly or service, they too, would have an unnaturally low capital base resulting in high ROIC. That does not make return on invested capital any less important; however, we introduce another measure, which is intended to evaluate the cash return on the company\u2019s deployment of resources\u2014its economic profit. The economic profit should then be compared to sales. Doing so can remove many of the distortions of ROIC and improve inter-company comparability.\u00a0 Even when ROIC makes sense, economic profit should be employed as another measure to evaluate the firm.<\/p>\n

Economic profit could also be related to other firm factors, such as total employees or units sold. Doing so would provide the analyst with comparability measures specific to a particular industry or situation. When used in this way, economic profit can indicate management ability to create value relative to its peer group or the direction and efficiency of its spending. For example, a pharmaceutical company analyst may wish to look at the economic profit per researcher.<\/p>\n

Economic profit is defined as a company\u2019s free cash flow exclusive of interest income minus a capital charge, with the charge calculated as the company\u2019s weighted average cost of capital multiplied by the operating invested capital<\/em><\/strong>. <\/em>The traditional definition of economic profit utilizes after-tax operating profits in lieu of free cash flow.<\/p>\n

Example<\/em><\/p>\n

Calculating the 2008 Economic Profit for 3M (MMM<\/a>) using the following financials:<\/p>\n

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From the free cash flow, interest income is subtracted since we are computing the economic return on the invested capital, not the total free cash flows, which include the returns on the financial assets as well.<\/p>\n

MMM\u2019s economic profit was $ 2.2 bn. during 2008<\/p>\n

When we compare MMM\u2019s economic profit to its 2008 revenues of $ 25,269 mil, we arrive at 8.9%, which could then be compared to its historic results or to other companies in its industry.\u00a0 The economic profit could also be related to employee headcount or other useful factors important to the company.<\/p>\n

Example:<\/em><\/p>\n

This is how Clorox (CLX<\/a>) computed its economic profit for fiscal years 2007-2009. As seen, it utilized a partial cash flow format by excluding some non-cash charges.<\/p>\n

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Source: Clorox Corp 2009 10K<\/p>\n

Clorox could have taken its definition a step further, as we did with MMM, by substituting free cash flow for operating profit, since operating profits are subject to GAAP and we are gauging cash return, to compare the result to revenues or other useful measures, including invested capital.\u00a0 We believe our definition of free cash flow and capital employed to be more reflective of invested capital than is Clorox\u2019s definition. Clorox uses a weighted average cost of capital (WACC) of 9% but doesn\u2019t reveal how that was determined. It is most likely they are using the Capital Asset Pricing Model (CAPM) to compute the equity cost of capital.<\/p>\n

I have found that firms that focus on economic profits as well as ROIC, have a greater tendency to engage in value creating opportunities. The beneficial effect of higher free cash flows results in superior stock performance for their shareholders. The trend toward using other entity\u2019s capital is not confined to the manufacturing sector, as service entities also deploying labor outside of their cost structure.<\/p>\n

Related articles:<\/p>\n