CHAPTER 7

Measuring Company Performance

In previous chapters, we saw that we can use financial statement information, and the ratio analysis of these statements, to get an idea of a company's performance. However, financial statement information may be problematic. Accounting principles are continually updated to provide for the best representation of a company's operating performance and financial position, yet because we apply a set of general accounting principles to companies in a variety of businesses, and because that financial information can be managed through a judicious use of accounting principles, concerns are raised about whether financial statement information is useful in financial analysis and valuation. Further, just looking at the values and income from the reported financial statements does not provide all the information we need to make projections about the future performance of a company.

So why not just look at stock prices as a measure of performance? If we dispose of financial statement information and focus solely on stock prices we have simply substituted one set of concerns for another. Evaluating a company's performance is much more challenging than looking at stock prices. If stock prices rise in a given period, does that mean the company is doing well? Not necessarily—the stock price may not be as high as it should be, given economic and market conditions. If a company's stock price declines during a given period, does that mean that the company is doing poorly? Not necessarily—the stock's price may be higher than expected given current economic and market conditions.

Arising from the need for better methods of evaluating performance, several consulting companies advocate performance evaluation methods that are applied to evaluate a company's performance as a whole and to evaluate specific managers' performances. These methods are, in some cases, supplanting traditional methods of measuring performance, such as the return-on-assets. As a class, these measures are often referred to as value-based metrics or economic value-added measures, though there is a cacophony of acronyms to accompany these measures, including economic value added (EVA®), market value added (MVA), cash flow return on investment (CFROI), shareholder value added (SVA), cash value added (CVA), and refined economic value added (REVA).1

A company's management creates value when decisions are made that provide benefits that exceed the costs. These benefits may be received in the near or distant future, and the costs include both the direct cost of the investment, as well as the less obvious cost, the cost of capital. The cost of capital is the explicit and implicit cost associated with using investors' funds. It is the attention to the cost of capital that sets the value-based metrics apart from traditional measures of performance.

This is a basic theme of capital budgeting: A company should only invest in projects that enhance the value of the company. So where do these value-enhancing projects come from? In a competitive market for investment opportunities, where many companies compete for available investment opportunities, there should be no value-enhancing projects. In other words, the cost of a project should be bid upward through competition so there is no net benefit from investing in the project. This explanation is rather gloomy and ignores the true source of value-enhancing projects: a company's comparative or competitive advantage. It is only through some advantage, vis-à-vis one's competitors, that allows companies to invest in projects that enhance value.2 In cases where there are no impediments to investment (that is, there is a competitive market for investments), it is only through having some type of advantage that a company can invest in something and get more back in return.

Stepping back from looking at individual projects to looking at an entire company, we can apply the same basic principles. If the company's investments provide future benefits greater than its costs, the investments enhance the value of the company. If the company's investments provide future benefits that are less than the investment costs, this is detrimental to the value of the company.3,4

From the perspective of analysts, the focus of performance evaluation is on the company as a whole, not on individual investment decisions within the company. The key to evaluating a company's performance is therefore whether the company's investment decisions, as a whole, are producing value for the shareholders. But there is no obvious technique to accomplish this because (1) we do not have the ability to perfectly forecast future cash flows from these investments; (2) we do not have accurate measures of the risks of each investment; and (3) we do not know the precise cost of capital. Therefore, we are left with using proxies (however imperfect) to assess a company's performance.

What makes a good performance measure? Ideally, a measure of a company's performance should have several characteristics:

TRADITIONAL PERFORMANCE MEASURES

The most widely cited performance measures are return-on-investment ratios, including the return on assets and the return on equity:

and

Generally, we associate higher return ratios with better performance. Return ratios are typically used in two ways. First, we often compare return ratios over time for a given company, where it is the trend, rather than the actual return for a particular period, which indicates performance. Second, we often compare return ratios across companies or with a benchmark, such as an industry average return or the return for the industry leaders.

An advantage of using return ratios in evaluating companies' performances is the ease of calculation. All information necessary for the calculation is readily available, either from financial statements or from market data. And, since the return is expressed as a percentage of the investment, its interpretation is straightforward.

An attractive feature of return ratios is the ability to decompose the return ratio to examine the source of changes in returns. As we saw in an earlier chapter, we can use the DuPont system to analyze return ratios, by breaking the return ratios into their activity, profit, and other components. This allows us to further evaluate the source of the return changes from year-to-year and to evaluate differences across companies.

A problem with the return on equity as a performance measure, despite its popularity, is that it can be managed through financing strategies. For example, if a company buys back its stock, the denominator will shrink and the return will increase. As another example, if the company borrows more, its financial leverage increases, increasing the return on equity. In both of these strategies, the company is more highly leveraged and therefore has more financial risk.

The return on assets is not affected by financing strategies, so it is preferred by some to the return on equity.5 This is especially important when comparing firms in the same industry: they have similar business risk, but likely different financial risk (i.e., capital structures).

In calculating the return on assets, there are several variations, including:

Return on investment measures may not be the best measures of performance for a number of reasons. First, we form return on investment ratios using financial statement data in the numerator and/or the denominator and therefore these ratios are sensitive to the choice of accounting methods. And this sensitivity to accounting methods makes it difficult to compare return ratios across companies and across time, requiring an adjustment of the accounting data to place return ratios on the same accounting basis.

Second, in creating these ratios, we are using financial data that is an accumulation of monetary values from different time periods. For example, the gross plant account includes the cost of assets purchased at different points in time. If there is significant inflation in some of the historical periods, this results in an “apples and oranges” addition problem for most accounts that affects total assets and equity, distorting the calculated returns on investment.

Third, return-on-investment ratios are backward-looking, not forward-looking. Though the immediate effects of current investments influence the return ratios, the expected future benefits from current period decisions are generally not incorporated in the return ratios.

A fourth reason for the deficiency of return-on-investment ratios is that they fail to consider risk. These ratios simply use historical financial statement data that in no way reflect the uncertainty the company faces.

Finally, the return-on-investment ratios do not adjust for controllable versus uncontrollable factors. Ideally, we would want to isolate the performance of the company from factors that are outside the control of management. Return on investment ratios simply reflect the bottom line and do not consider any other factors.

MEASURES OF VALUE ADDED

Before looking at measures of value added, let's first look at the sources of value added, using Michael Porter's five forces. Considering Porter's five forces helps the analyst focus on the company's competitive advantage and identify the company's key sources of value added.

Porter's Five Forces

Michael Porter analyzed the competitive structure of industries and identified five competitive forces as shown in Exhibit 7.1.6 These forces capture an industry's competitive rivalry:

• The bargaining power of suppliers.
• The threat of new entrants.
• The threat of substitute products.
• The bargaining power of buyers.
• The degree of rivalry.

The bargaining power of suppliers is a force related to the providers of inputs—both goods and services. Suppliers' bargaining power is greater when the market in which they operate is dominated by a few large companies, there are no substitutes for the input, the cost of switching inputs is high, the buyers are fragmented with little buying power, and the suppliers may integrate forward to capture higher prices and margins.

The bargaining power of customers is high when they purchase large quantities of goods or services, the buyers are concentrated, the suppliers have high fixed costs, and there are ready substitutes or the buyer could produce the good or service itself.

The threat of new entrants is high when there are few barriers to entry. A barrier to entry is an impediment such as economies of scale, high initial start-up costs, cost advantages due to experience of existing participants, loyalty among customers, and protections such as patents, licenses, copyrights, or regulatory or government action that limits entrants into the industry.

The threat of substitutes is high when there is little brand loyalty among customers, there are no close customer relations, there are low costs to switching goods or services, and there are substitutes that are lower priced.

The competitive rivalry among existing members of the industry is affected by the number and relative size of the companies in the industry, the strategies of the companies, the differentiation among products, and the growth of the sales in the industry.

Porter's forces are, basically, an elaboration of the theories of economics that tell us how a company creates economic profit. Though Porter's forces may be criticized for being oversimplistic in a dynamic economy, they provide a starting point for analysis of a company's ability to add value. Porter argues that an individual company may create a competitive advantage through relative cost, differentiation, and relative prices. A financial analyst, in evaluating a company's current and future performance, can use these forces and strategies to identify a company's competitive advantage. For it is through a competitive advantage that a company creates value.

Measures of Value Added

The most prominent of recently developed techniques to evaluate a company's performance is the value-added measures of economic profit and market value added (MVA).7 These measures have links to our fundamental valuation techniques.8 Value-added measures are based on the same valuation principles as the net present value capital budgeting technique. But remember: value is not created out of thin air, but rather from a company's competitive advantage.

A net present value for a specific investment project is the estimate of change in the value of equity if the company invests in the project. The value-added measures also produce an estimate of the change in the value of the company, but relate to the company as a whole, rather than a specific project. Further, whereas net present value is forward looking, assisting management in making decisions dealing with the use of capital in the future, measuring a period's performance using value-added measures focuses on the decisions that have been made during a period and the cost of capital that supported those investment decisions to help us gauge how well the company has performed.

There are a number of value-added measures that an analyst can calculate. The most commonly used measures are economic profit and market value added. Key elements of estimating economic profit are the:

• Calculation of the company's operating profit from financial statement data, making adjustments to accounting profit to better reflect a company's results for a period.
• Calculation of the company's cost of capital.
• Comparison of operating profit with the cost of capital.

The difference between the operating profit and the cost of capital is the estimate of the company's economic profit, or economic value added.

A related measure, market value added, focuses on the market value of capital, as compared to the cost of capital. The key elements of market value added are the:

• Calculation of the market value of capital.
• Calculation of the capital invested.
• Comparison of the market value of capital with the capital invested.

The difference between the market value of capital and the amount of capital invested is the market value added. The primary distinction between economic value added and market value added is that the latter incorporates market data in the calculation.

It is difficult to measure whether a company's management has increased or decreased a company's value during a period because a company's value may be affected by many factors. Currently advocated performance measurement techniques, such as Stern Stewart's EVA® and MVA, are based on valuation principles. However, there is an important distinction between valuation and performance measurement: Valuation relies on forecasts, whereas performance measurement must rely on actual results.

Economic Profit

Many U.S. corporations embraced a method of evaluating and rewarding management performance that is based on the idea of compensating management for economic profit, rather than for its accounting profit. What is economic profit? Economic profit is the difference between revenues and costs, where the costs include not only expenses, but also the cost of capital. And though the application of economic profit is relatively new in the measurement of performance, the concept of economic profit is not—it was first noted by Alfred Marshall in the nineteenth century.9 What this recent emphasis on economic profit has done is focus attention away from accounting profit and towards economic profit.

The cost of capital is the rate of return that is required by the suppliers of capital to the company. For a business that finances its operations or investments using both debt and equity, the cost of capital includes not only the explicit interest on the debt, but also the implicit minimum return that owners require. This minimum return to owners is necessary so that owners keep their investment capital in the company.

So, where does economic profit come from? From the company's competitive or comparative advantage. The challenge that the analyst faces is examining the company in light of Porter's “five forces” and identifying what advantages, if any, a company has. For it is only through these advantages that a company can generate a sustainable economic profit and, hence, create value. In other words, a company creates value when it generates profit over and above that expected for the level of risk it assumes—therefore “clearing” the hurdle that is its cost of capital.

Economic Profit vs. Accounting Profit

There are two important distinctions between accounting profit and economic profit. The first distinction deals with the cost of capital. Accounting profit is the difference between revenues and costs, based on the representation of these items according to accounting principles. Economic profit is also the difference between revenues and costs, but, unlike the determination of accounting profit, we include the cost of capital in the costs.

The second distinction between accounting and economic profit deals with the principles of recognition of revenues and costs. We determine accounting profits based on the accrual method, whereas we calculate economic profits using cash-basis accounting. However, since the only data reported in financial statements is in terms of accrual accounting, analysts calculating economic profits must first start with accounting profits and then make adjustments to place the data on a cash basis. This adjustment is imperfect, but does help us better gauge performance than relying solely on accounting profits.

Further, we make adjustments to accounting profits to compensate for distortions that may arise from the choice of particular accounting methods. For example, companies with operating leases account for these leases as rental expenses, with no liability on the balance sheet; however, analysts often capitalize these leases to make their presentations similar to that of capital leases. Unlike accounting profit, economic profit (if measured accurately) cannot be manipulated by management through the choice of accounting methods.

In addition to the use of economic profit measures for compensating managers, financial analysts are incorporating the basic principles of economic profit in their assessment of corporate success. Performance measures based on economic profit are known by several different names, including market value added (MVA), economic value added (EVA®), and excess shareholder value.

Economic Profit and Net Present Value

We estimate economic profit in a manner analogous to the net present value method of evaluating investments. Though attractive in principle, there are many pitfalls associated with the application of the net present value capital budgeting technique to actual companies. These pitfalls include (1) the use of accounting data to determine economic profit, and (2) the estimation of the cost of capital.10

Just as the net present value of a project produces results that are sensitive to the cost of capital, so does the economic profit approach. Any slight change in the cost of capital estimate may change the estimated value added from positive to negative or vice-versa. In other words, whether we view a company's performance as value-destroying or value-enhancing is sensitive to the estimates used in the calculation.

The net present value method, as applied in the context of evaluating performance of companies and management, was brought to prominence by G. Bennett Stewart III in his book A Quest for Value: A Guide for Senior Managers (New York: HarperCollins, 1991) and through the consulting work by Stern Stewart.

Calculating Economic Profit

Economic profit, referred to as economic value added, is the difference between operating profits and the cost of capital, where the cost of capital is expressed in dollar terms. The application to an entire company involves, essentially, calculating the net present value of all investment projects, both those involving existing assets (that is, past investment decisions) and those projected.

We can describe economic profit as:11

or, equivalently, using the spread between the rate of return and the percentage cost of capital,

where the return on capital is the ratio of net operating profit after taxes to capital.

Application of this formula produces an estimate of the economic profit for a single period. In evaluating a company's performance for a given period, economic profit reflects whether value is added (a positive economic profit) or reduced (a negative economic profit). Each element of this formula is discussed in detail next.

Net Operating Profit after Taxes

There are two important elements in the calculation of net operating profit after taxes (NOPAT): operating profit after depreciation and cash operating taxes. NOPAT is income from operations, but after we remove the taxes on a cash basis that are related to operating income. Cash operating taxes are taxes on operating income, placed on a cash basis.

Operating income after depreciation is used rather than the traditional operating income before depreciation because depreciation is considered an economic expense: Depreciation is a measure of how much of an asset is used up in the period, which gives us an idea of how much must be expended to maintain operations at the existing level.

In addition to using cash operating taxes instead of the tax expense on the income statement, there are several adjustments intended to alter accounting profit to better reflect economic profit. However, because these adjustments involve adjusting accounting profit to arrive at economic profit, these adjustments must be tailored to the company's specific accounting practices and situation.

Whether you start with operating profit after depreciation (the “bottom-up” approach),

or begin with sales (the “top-down” approach),

we arrive at net operating profit after taxes, that is, NOPAT.

Let's calculate 2010 NOPAT for McDonald's Corporation to see how these adjustments are made to actual company data. Using the basic income statement data as presented as an example in Exhibit 7.2, balance sheet data in Exhibit 7.3, financial statement note information (not shown in table), and the bottom-up approach, we begin with operating profit after depreciation and amortization (i.e., operating income) of $3,540.5 million.

EXHIBIT 7.2 McDonald's Balance Sheet

	As of …
	12/31/2010	12/31/2009
Cash and equivalents and short-term investments	$2,387.0	$1,796.0
Receivables, short-term	1,179.1	1,060.4
Inventories	109.9	106.2
Other current assets	692.5	453.7
Total current assets	$4,368.5	$3,416.3
Gross property plant and equipment	$34,482.4	$33,440.5
Accumulated depreciation	12,421.8	11,909.0
Net property plant and equipment	$22,060.6	$21,531.5
Long-term investments	1,335.3	1,212.7
Intangible assets	2,586.1	2,425.2
Other assets	1,624.7	1,639.2
Total assets	$31,975.2	$3,0224.9
Accounts payable	$943.9	$636
Accrued expenses	476.3	473.2
Current debt	8.3	18.1
Other current liabilities	1,496.2	1,861.4
Total current liabilities	$2,924.7	$2,988.7
Long-term debt and leases	1,1497	10,560.3
Deferred long-term liabilities	1,332.4	1,278.9
Other liabilities	1,586.9	1,363.1
Total liabilities	$17,341	$16,191
Common share capital	$16.6	$16.6
Additional paid-in capital	5,196.4	4,853.9
Retained earnings	33,811.7	31,270.8
Accumulated other comprehensive income	752.9	747.4
Treasury stock	(25,143.4)	(22,854.8)
Total equity	$14,634.2	$14,033.9
Total liabilities and equity	$31,975.2	$30,224.9
Source of data: McDonald's, 2010 annual report.

EXHIBIT 7.3 McDonald's Income Statement

	12/31/2010	12/31/2009
Total revenue	$24,074.6	$22,744.7
Cost of goods sold	14,437.3	12,651.2
Gross profit	$9,637.3	$10,093.5
Selling general and administrative expenses	2,333.3	2,234.2
Other operating expense	4.80	283.4.3
Operating income	$7,473.1	$6,841.0
Interest expense	450.9	473.2
Gains on sale of assets		94.9
Other nonoperating expense (income)	21.9	(24.3)
Earnings before tax	$7,000.3	$6,487.0
Taxation	2,054.0	1,936.0
Net income	$4,946.3	$4,551.0
Source of data: McDonald's, 2010 annual report.

Most of the information necessary to make the adjustments is available directly from the financial statements or the notes to financial statements. The only adjustment applicable to McDonald's is for implied interest on operating leases, which is implied from future rental commitments, as detailed in the “Leasing arrangements” note of the McDonald's Corporation 2010 annual report.12

McDonald's implied interest expense on operating leases must be calculated using note information. The interest expense is estimated as the interest cost on the change in the average value of leases during the year. This requires estimating the present value of leases at the beginning and end of the year.

We calculate the present value of operating leases by discounting minimum rental commitments on operating leases for the next five years. These minimum rental commitments are disclosed in a footnote to the financial statements. In the case of McDonald's, the expected future commitments beyond 2010 are as follows:

	Operating Lease Rental Commitment (in millions)
Year following	2010	2009
First year	$1,201	$1,119.4
Second year	1,116	1,046.5
Third year	1,034	963.4
Fourth year	926	885.4
Fifth year	827	805.9
Beyond the fifth year	$11,121	$10,717.5

Using a discount rate of 5.5% (the approximate yield on McDonald's debt in 2010), the present value of the first five years of commitments is $4,402 million. Because many companies disclose only rental commitments for the next five years, the value of the commitments beyond the fifth year are often ignored in the determination of capital. In the case of McDonald's, this may amount to a large difference in estimated debt capital.13

Repeating the same analysis for 2009, the present value of the operating leases is $4,135 million. The average lease value for 2010 is therefore ($4,064 + 4,135) ÷ 2 = $4,277 million. Using an interest rate of 5.5%, the interest on the leases is estimated to be $235.26 million. This implied interest is backed out of operating profit because it represents a financing cost that is deducted to arrive at reported operating profit.

Starting with the operating profit after depreciation and amortization from the 2010 income statement, adjusted operating profit before taxes for McDonald's is calculated as:

	Amount (in millions)
Operating profit after depreciation and amortization	$7,473.1
Add: Implied interest on operating leases	235.3
Adjusted operating profit before taxes	$7,708.4

Cash-Operating Taxes

Cash-operating taxes are estimated by starting with the income tax expense and adjusting this expense for:

The change in deferred taxes is removed from the income tax expense because:

• an increase in deferred taxes means that a portion of the income tax expense that is deferred is not a cash outlay for the period, and
• a decrease in deferred taxes means that the income tax expense understates the true cash expense.

The tax benefit from interest is added back to taxes so that the cash taxes reflect the taxes from operations. This gross-up of taxes isolates the taxes from any financing effects. This tax benefit is the reduction of taxes from the deductibility of interest expense:

The taxes from other nonoperating income and special items (e.g., sales of investment interest) are also removed so that the cash taxes reflect solely those taxes related to operations.

Let's look at an example using the McDonald's 2010 financial data. First, we calculate cash taxes, using a marginal tax rate of 35%, as we show in Exhibit 7.4.

Subtracting cash operating taxes from the adjusted operating profit produces net operating profit after taxes (NOPAT):

	Amount (in millions)
Adjusted operating profit before taxes	$7,708.4
Less: Cash operating taxes	2,237.2
Net operating profit after taxes (NOPAT)	$5,471.2

EXHIBIT 7.4 Calculation of Cash Operating Taxes for McDonald's, 2010

This approach to calculating NOPAT is a “bottom-up” approach since it starts with operating profit after depreciation and amortization and builds to NOPAT. Another approach is a “top-down” approach, where we start with sales and adjust to arrive at NOPAT. In the case of McDonald's for 2010, the NOPAT is shown in Exhibit 7.5.

EXHIBIT 7.5 Top-Down Calculation of NOPAT for McDonald's, 2010

Whether we use the top-down approach or the bottom-up approach, we can arrive at the NOPAT of $5,471.2 million.

Capital

Capital in this context is the sum of net working capital, net property and equipment, goodwill, and other assets. Another way of looking at capital is that it is the sum of the long-term sources of financing, both debt and equity, that are invested in the company. Therefore, this sum is often referred to as invested capital.

When calculating a company's capital, we need to make several adjustments to reported accounts to correct for possible distortions arising from accounting methods. For example, we adjust inventory for any LIFO reserve, we include the present value of operating leases as part of invested capital, and we add back any accumulated goodwill amortization to capital.

We must peruse the footnotes for the financial statements to arrive at these adjustments. The calculation of capital should, ideally, be tailored to reflect each company's financial accounting. You will also notice that the adjustments we made to arrive at NOPAT have companion adjustments to arrive at capital. And, as with the NOPAT calculations, we can arrive at capital by starting at either of two points: total assets (the asset approach) or book value of equity (sources-of-financing approach).

Using the asset approach, we begin with net operating assets and then make adjustments to reflect total invested capital:

For example, it can be argued that goodwill generated from paying more when acquiring a company than its assets' book value is an investment. Using this reasoning, we add both goodwill and prior periods' amortization of goodwill to capital to reflect the company's asset investment.15

Using another approach, the source-of-financing approach, we begin with the book value of common equity and add debt, equity equivalents, and debt equivalents:

Continuing our example using McDonald's, we estimate capital using the asset approach. We begin with net operating assets and adjust for plant and equipment, other assets, and the value of the operating leases. Operating current assets include cash, marketable securities, receivables, inventories, and other current assets. For McDonald's in 2010, these amount to $4,368.5 million.16 Net operating assets are operating current assets, less operating current liabilities, such as accounts payable, which are $1,652.8 million for McDonald's.

We show our calculations of McDonald's capital in Exhibit 7.6 (starting with net operating assets) and Exhibit 7.7 (starting with the book value of common equity). In either calculation, the amount of capital for McDonald's for the 2010 fiscal year is $33,537 million.

EXHIBIT 7.6 Calculation of Capital for McDonald's Using the Asset Approach, 2010

EXHIBIT 7.7 Calculation of Capital for McDonald's Using the Sources-of-Financing Approach, 2010

Some consultants make a further distinction between invested capital (as described above) and operating capital.17 Operating capital is invested capital less goodwill. In other words, operating capital is the amount of the investment employed in operations. Goodwill is removed as capital because it tends to be distorted by premiums paid in acquiring other companies.18 Goodwill for McDonald's in 2010 is $2,586.1 million and accumulated goodwill amortization is not determinable from published financial statements. Removing goodwill from invested capital produces operating capital of $30,950.9 million.

Return on Capital

We calculate the return on capital by dividing operating income after taxes by capital. This measure is a return on investment measure, using NOPAT instead of accounting profit:

The return on capital for McDonald's is the ratio of the NOPAT to invested capital, or

The return on operating capital for McDonald's is somewhat higher because of the exclusion of goodwill in the denominator:

Which return measure is best to use in evaluating McDonald's? It depends on whether you are focusing on (1) McDonald's ability to profitably and efficiently use investors' funds (including funds used to acquire other companies at a premium), which requires use of the former measure; or (2) McDonald's ability to profitably and efficiently use its operating assets (allowing better comparability across companies in the same industry), which requires the use of the latter measure.

Cost of Capital

The cost of capital is the cost of raising additional funds from debt and equity sources. For each source, there is a cost. Once the cost of each source of capital is determined, the cost of capital for the company is calculated as a weighted average of each cost, where the weight represents the proportionate use of each source.

The cost of debt is the after-tax cost of debt, rd*, adjusted for the benefit from the tax-deductibility of interest:

where the before tax rate, rd, is the prevailing yield on long-term bonds of companies with similar credit risk. For example, at the end of 2010, bonds of similar risk to McDonald's yielded approximately 5.5%. Using the marginal tax rate of 35%, the after-tax cost of debt for McDonald's is

There are different methods used to estimate the cost of equity capital, which is the return that shareholders require on their investment. Using the widely accept approach that is based on the capital asset pricing model, the cost of equity capital is the sum of the risk-free rate of interest and the premium for bearing market risk:

where rf is the risk-free rate of interest, rm is the expected return on the market, and β is the stock's beta.19

This calculation is not as straightforward as it looks. One issue is the appropriate proxy for the risk-free rate. The risk-free rate of interest should, theoretically, be the return on a zero-beta portfolio with a duration similar to the holding period of the investor. Because this estimation task is extremely difficult, an alternative is to proxy the risk-free rate using rates on securities that market participants might view as having no default risk or very minimal default risk; that is, U.S. government debt. If a government obligation with a short duration is used, such as a Treasury bill, there is a mismatch of the duration between the Treasury bill and the risk-free portfolio. A more suitable proxy is the 10-year Treasury bond because this matches the duration of the market portfolio.20

Another issue is the premium for market risk, (rm − rf). Stewart advocated a 6% market risk premium, based on the historical spread between the return on the market and the return on long-term government bonds.21 Copeland, Koller, and Murrin advocate a slightly different approach, using the difference between the geometric mean return on the market and that of the long-term government bonds, both calculated over a long time frame. They estimate that the risk premium may range between 3% and 8%, and that the estimate is sensitive to the period over which the estimate is made. Damodaran uses a value in between these two, 5.5%, in his estimations.22 More recent evidence suggests a risk premium around 3.5% coinciding with the recent financial crisis.23 For the purposes of demonstrating the calculation, we use a 5% market risk premium.

The market risk premium is tailored to the company's specific risk premium by multiplying the market risk premium by the company's common stock beta, β. The beta is a measure of the sensitivity of the returns on the company's stock to changes in the returns on the market. Estimates of beta are readily available from financial services such as MSCI Barra, Standard and Poor's Compustat, Yahoo! Finance, or Value Line. McDonald's beta is 0.65.24 Using the 10-year Treasury bond rate of 3.3%, a market risk premium of 5%, and a beta of 0.65, McDonald's cost of equity is

In sum, the cost of capital of McDonald's is comprised of the cost of debt of 3.575% and the cost of equity of 6.55%. We weight the costs of debt and equity using the proportions each represents in the capital structure to arrive at a cost of capital for the company.

The first step is to determine the book-values of debt and equity. One method is to use the debt and equity book values that we determined in the calculation of capital. Another method is to estimate the market value of the capital components. This requires estimating the market value of both debt and equity.

McDonald's capital structure at the end of 2009 (and hence the beginning of 2010) consists of:25

McDonald's capital structure at the end of 2010 consists of:

Additions and subtractions to debt and equity capital are made throughout the year. Because of this and the lack of specific data on changes in capital, we can approximate the capital proportions by averaging the beginning and ending capital proportions for the year. Using book values, this gives us approximately 52% debt and 48% equity. The weighted average cost of capital using the book weights and a 9.5% cost of equity, is

Using market value weights, the cost of capital is greater because approximately 71.1% of its capital is equity:

Which do we use: 5.1% or 6%? In most applications, we choose the method that best reflects the marginal cost of funds. If the company raises an additional dollar of capital, in what proportion does it raise these funds? We usually think of this in terms of the market value proportions, using the 6% cost of capital. But in this particular application, we are applying this cost of capital against the invested capital, which is most often stated in terms of book values. Mixing a market value determined cost of capital with book value of invested capital results in distortions.26 Therefore, we use the book value weighted cost of capital in determining economic profit (that is, the 5.1%).

Economic Profit and Performance

Economic profit is the profit generated during the period in excess of what is required by investors for the level of risk associated with the company's investments. Economic profit is analogous to the net present value of capital budgeting, and represents the value added by the company's management during the period.

Suppose we assume that McDonald's cost of capital is 6%. Using the two, equivalent economic profit calculations, we see that McDonald's management generated an economic profit in 2010:

McDonald's earned an economic profit of $3,460.1 million in 2010. In other words, McDonald's management added value during 2010.

Though it seems that McDonald's added value during the period, as represented by the estimate of economic profit, the estimate of economic profit is always sensitive to the estimate of the cost of capital. The cost of capital is something that is difficult to measure. Looking at a range of cost of capital, plus and minus 100 basis points, gives an idea of this sensitivity:

Drawing a conclusion regarding the degree of profitability depends, in large part, on the estimated cost of capital, among other assumptions.

Market Value Added

A measure closely related to economic profit is market valued added. Market value added is the difference between the company's market value and its capital. Essentially, market value added is a measure of what the company's management has been able to do with a given level of resources (the invested capital):

Like economic profit, market value added is in terms of dollars and the goal of the company is to increase added value. Being top of the list of companies ranked on the basis of market value added does not mean that the company has outperformed other companies. It merely means that the company has the greatest difference between its book and market values of capital—accumulated over time. Rather, performance is evaluated by looking at the change in market value added over a period. The change in the market value added is a measure of how effectively the company's management employs capital to enhance the value of capital to all suppliers of capital, not just common shareholders.27 The change in market value added is the change in the market value of capital (debt and equity), less the change in the book value of capital.

Looking once again at McDonald's, we see the following for 2010 and 2009:

This analysis tells us that McDonald's management has increased the market value added in 2010, adding $12,991.4 million more in market value in excess of invested capital.

It is often the case in application that the book value of debt and the book value of preferred stock are used in estimating both the market value of capital and the book value of capital.28 Therefore, the change in market value added from one year to the next amounts to the change in the market value of common equity, plus the change in the book value of debt and preferred stock. Because of this measurement of market value added, the change in market value added is determined, in large part, by the change in the market value of the common stock. Therefore, the change in market value is affected by the change in the value of the market in general.

Reconciling Economic Value Added with Market Value Added

There are two different value added measures: economic value added (economic profit) and market value added. Economic value added is based on the adjusted operating earnings (after taxes), invested capital, and the company's weighted average cost of capital. Market value added is based on a comparison of invested capital with the market value of capital. These two measures are both designed to help evaluate the performance of a company.

There is a logical link, however, between market value added and economic profit. The market value added should be equal to the present value of future periods' economic profit, discounted at the cost of capital. If we assume that the company will generate future-period economic profit equivalent to this period's economic profit, in perpetuity, the relation between market value and economic profit is a simple one:

Yet, the perpetuity assumption is not valid for most companies because of a very basic notion: economic profits are generated only when a company has some comparative or competitive advantage. Most companies cannot maintain these advantages for long periods of time; for example, government regulations may change, patents are not perpetual, and demographics change, all of which can erode a company's advantage and, hence, its economic profit. Therefore, the assumption of a perpetual stream of the current period's economic profit is not reasonable in most cases.

Another reason why this relation does not hold in application is that the methods of determining economic profit and market value added are quite different. Economic value added is a single-period measure, estimated using accounting data and an estimated cost of capital. Market value added employs market values, which are more forward-looking estimates of performance. In practice, however, economic profit and market value added may result in conflicting evaluations of performance.29,30

Still another reason why this relation does not hold true is that the estimates of economic profit are just that—estimates. Economic profit is estimated by starting with accounting data and making adjustments to better reflect economic reality. However careful an analyst is in adjusting the accounting data, the estimated economic profit cannot precisely reflect true economic profit.

Challenges in Applying Value-Added Measures

Even advocates of economic profit do not prescribe a particular formula for calculating economic profit. Economic profit has ambiguous elements, most notably the adjustments to operating income and the cost of capital.31 Conceivably, two analysts could calculate economic profit, yet draw different conclusions regarding companies' relative performance.

The calculation of operating income (i.e., NOPAT) requires that each company be treated as an individual case. The adjustments to arrive at operating profits after taxes are different for each company and there may be over 150 adjustments applied. This makes it difficult to apply from the perspective of the financial analyst who must rely on financial statements and other publicly available information to determine economic profit. Though a formula could be developed to deal with the most common adjustments, there are always exceptions to the general rules that must be dealt with.

There are also many ambiguities regarding the measurement of the cost of capital. One problem is determining the best model for the estimate of the cost of equity. Should the analyst use the capital asset pricing model or the dividend valuation model?32 Suppose the analyst uses the capital asset pricing model, which requires specifying a market risk premium (that is, the additional required return for bearing market risk). Should the market risk premium be 5%? 6%? In some cases the choice matters, making the difference between a value-adding company and a value-destroying company.

Another problem with the estimation of the cost of capital is the choice of weights to apply to the difference costs of capital. Though market weights are theoretically appealing, many apply weights based on book values. Whether these issues affect the assessment of performance and relative performance is, of course, an empirical issue.

But Are Value-Added Measures Better?

Whether the value-added measures aid the financial analyst in assessing the operating performance and financial condition of a company is really an empirical issue.33 What we know from an analysis of the economic profit (a.k.a. economic value added) is that it has a solid foundation in economic and financial theory. Using economic profit instead of accounting earnings is attractive because it avoids the problems associated with accounting earnings.

Are companies that generate more economic profit than others better companies? Not necessarily. First, we estimate economic profit as a single period measure, using the current period's financial information. Just like a return on investment ratio, focusing on economic profit is short-sighted. It may be the case that the company is sacrificing future profitability to generate current period economic profit.

Second, we calculate economic profit using the company's cost of capital as the “hurdle.” But if the company has taken on activities that are riskier than the company's typical activities, the calculation of the cost of capital and economic profit may not reflect this increased risk-taking, resulting in an overstatement of current profitability.

Third, NOPAT and the cost of capital are just estimates. Even slight variations in the assumptions and estimates can result in dramatic changes in measured profitability.

Fourth, we state economic profit in dollar terms, but this is misleading when comparing companies of different sizes. According to the Stern Stewart's 2002 Russell-3000 rankings, Microsoft generated $2,201 million of economic profit, whereas Proctor & Gamble Company generated $2,315 million.34 So which one performed better? Comparing economic profit, Procter & Gamble appears to be approximately the same as Microsoft, but once you look at the amount of invested capital (that is, what they invested to generate that economic profit), you get a different picture: Procter & Gamble's invested capital is almost twice that of Microsoft's.

So if there are problems associated with measuring economic profit, what good is it? Well, in theory economic profit is a measure of a company's performance over a period of time, so if we can overcome the measurement issues we have a measure that is superior to accounting income. And if measured in a consistent manner across companies or across time it can be used to compare performance. Further, economic profit in theory is related to market value added: market value added is the present value of future periods' economic profit. If investors' valuation of future economic profit is market value added, and if current and recent periods' economic profits are predictors of future economic profit, we can use economic profit in assessing the value of a share of stock. This suggests that trends in economic profit suggest future value changes. For example, continued improvements in economic profit suggest that value is being added and we should see an increase in market value added. In a similar vein, if economic profit is declining, we should see a decline in market value added.

Suppose that we focus on market value added. Is this a better measure of the performance of a company than, say, return on assets? Going back to the definition of market value added, we see that a company increases its market value when the change in the market value of its capital (that is, the market value of its debt and equity) exceeds the change in its invested capital (that is, book value of its debt and equity). Because most of the measures of market value added use the market value of equity and assume that the market value of debt is equal to the book value of debt, the change in the market value added is really attributed to the change in the stock's price. Therefore, it should be no surprise that the change in the market value added is highly correlated with a company's stock's return.

SUMMARY

The value-added measures of economic profit and market value added are really nothing new—it is their application in performance measurement within firms and in financial analysis that is new. Economic profit is the operating profit of a company less its cost of capital. The calculation of operating profit for this purpose requires adjustments to remove distortions resulting from the application selected accounting principles. There can be more than 150 adjustments and these adjustments must be tailored for the individual company.

Traditional performance measures, such as the return on assets, are not forward-looking, do not capture risk, and do not control for factors outside of the control of the company. Additionally, unless care is taken in the construction of these measures, these measures may be affected by the choice of accounting methods.

The calculation of economic profit requires financial statement data, notes to financial statements, and, in most cases, information beyond published financial information. This makes the calculation of economic profit challenging to the financial analyst. Calculating economic profit also requires determining the amount of a company's invested capital. Adjustments to arrive at operating income for the economic profit calculation have companion adjustments to arrive at invested capital. The cost of capital is generally determined by using a weighted average of the costs of capital. However, there are many assumptions and complexities in the calculation of the cost of capital and any estimate is subject to possible measurement error because a company's cost of capital cannot be observed.

Market value added is the difference between the market value of a company's capital and the amount of invested capital (i.e., book values of capital). Performance measurement requires determining the change in market value added because the total market value added is measured over the company's entire history.

If used with the understanding of what the value added measures can and cannot do, the financial analyst may benefit from including these measures along with the traditional measures.

REVIEW

1. EVA® is a registered trademark of Stern Stewart.

2. A comparative advantage is the advantage one company has over others in terms of the cost of producing or distributing goods or services. A competitive advantage is the advantage one company has over another because of the structure of the markets (input and output markets) in which they both operate.

3. The idea of producing current value from future investment opportunities is reflected in the concept of franchise value, which is discussed by Kogelman and Liebowitz in their decomposition of the price-earnings (P/E) ratio into a franchise P/E and a base P/E. See Stanley Kogelman and Martin L. Liebowitz, “The Franchise Factor Valuation Approach: Capturing the Company's Investment Opportunities,” in Corporate Financial Decision Making and Equity Analysis (Charlottesville, VA: Association for Investment Management and Research, 1995), 5−10. In their analysis, future investment opportunities in excess of market returns are reflected in above-market P/E ratios.

4. This is what Warren Buffett is talking about when he refers to a “sustainable competitive advantage” or “enduring competitive advantage” in his letters to shareholders. See, for example, Letters to Berkshire Hathaway Shareholders in 1999, 2000, and 2004, available at www.berkshirehathaway.com.

5. John Hagell III and John Seely Brown, “The Best Way to Measure Company Performance,” HBR Blog Network, March 4, 2010, blogs.hbr.org/bigshift/2010/03/the-best-way-to-measure-compan.html

6. Michael Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Simon & Schuster, 1998).

7. A particular calculation of economic profit, promoted by the consulting firm of Stern Stewart, is economic value added (EVA®). A detailed description of the value-added methods can be found in G. Bennett Stewart III, The Quest for Value: A Guide for Senior Managers (New York: HarperCollins, 1991). We will refer to economic value added by its original name of economic profit. Another prominent valuation approach is the discounted cash flow approach, advocated by McKinsey and Co. This approach involves forecasting future periods' free cash flows, forecasting a company's continuing value at the end of the forecast period, and discounting the future free cash flows and the continuing value at the company's weighted average cost of capital. Because this approach involves valuation based on forecasts, it is not a suitable device for evaluating performance, though it is useful in setting performance targets. See Thomas Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd ed. (New York: John Wiley & Sons, 2000).

8. For a detailed discussion of value-based metrics, see Frank J. Fabozzi and James L. Grant (eds.), Value Based Metrics: Foundations and Practice (New York: John Wiley & Sons, 2000); and Frank J. Fabozzi and James L. Grant, “Equity Analysis Using Traditional and Value-Based Metrics,” in Valuation, Financial Modeling, and Quantitative Tools, vol. 3 of The Handbook of Finance, ed. Frank J. Fabozzi (Hoboken, NJ: John Wiley & Sons, 2008).

9. Alfred Marshall, Principles of Economics, vol. 1 (New York: Macmillan & Co., 1890), 142.

10. The cost of capital is an opportunity cost of funds, measured as the weighted average of the marginal costs of debt and equity capital.

11. Stewart, The Quest for Value, 136.

12. Information on change in bad debt reserve is not available in McDonald's financial statement, likely because these items are immaterial. Therefore, these adjustments are not made. This illustrates a potential problem in calculating economic profit: the information needed may not be available in published financial reports.

13. If McDonald's rental commitments beyond the fifth year are, say $800 million per year, the difference in estimated debt capital (using a 5.5% discount rate) is over $12,000 million: discount the $800 per year as a perpetuity to the end of the fifth year ($800/0.055 = $14,545.45), and then discount this amount back five years (Present value = $11,129 million).

14. Although the amount is typically small, an adjustment for the taxes on other non-operating income is suggested by Copeland, Koller, and Murrin, Valuation: Measuring and Managing the Value of Companies.

15. Though goodwill amortization is no longer permitted, many companies have amortized goodwill in the past such that the value reflected on the balance sheet is net of amortized goodwill from years in which goodwill was amortized.

16. Information on bad-debt reserve, capitalized research and development, and cumulative write-offs was not available in the financial statements. The extent to which these omissions affect the resultant economic value-added measure is unknown, but these items are also omitted in published examples of economic profit due to unavailability of the data [see, for example, the explanations accompanying the Wal-Mart example in Stern (1991, page 99)].

17. Copeland, Koller, and Murrin, Valuation.

18. Another possible adjustment is for excess cash and marketable securities. Excess cash and marketable securities are those in excess of the typical need for cash and marketable securities. Copeland, Koller, and Murrin in Valuation estimate that the need for cash and marketable securities is between 0.5% and 2% of sales, varying by industry.

19. Beta is the estimated slope coefficient using regression analysis that relates the returns on the stock to the returns on the market.

20. See Copeland, Koller, and Murrin, Valuation, for a discussion of the comparability of durations. Stewart in The Quest for Value specifies that this rate should be the rate on a long-term government bond. Copeland, Koller, and Murrin are more specific, advocating the rate on a 10-year U. S. Treasury bond. Using the latter approach, the risk-free rate for 2010 is 3.33%.

21. Stewart, The Quest for Value.

22. Available at the web site of Aswath Damodaran, Damodaran Online (pages.stern.nyu.edu/~adamodar/).

23. John R. Graham and Campbell R. Harvey, “The Equity Risk Premium amid a Global Financial Crisis,” in Lessons from the Financial Crisis, ed. Robert Kolb (Hoboken, NJ: John Wiley and Sons), 2010: 525-536.

24. The beta 0.65 is taken from Value Line Investment Survey.

25. In addition to estimating the company's most recent market value capital components, it is useful to look at the capital structure of other companies in the industry and to consider the trends in the company's capital structure over time, because the capital structure of a company at a point in time may not reflect the company's target capital structure.

26. The extent of the distortion depends on the relation between the market value of capital and the book value of capital.

27. A related issue is whether the company's management should be striving to maximize the value of the company or to maximize the value of common equity. The market value-added measure focuses on the former, whereas more common measures, such as stock returns, focus on the latter. In general, maximizing the value of the company will result in the maximization of shareholders' wealth.

28. See, for example, Stewart, The Quest for Value, 153-154.

9. As we have shown previously, slight differences in the estimated cost of capital can result in quite different conclusions regarding economic profit and, hence, performance.

30. As you can see, this equation is nonsensical in the case in which there is an economic loss and a positive market value added.

31. This is not the fault of economic profit, per se, but rather the starting point of the calculations: reported financial statements prepared according to GAAP.

32. Most applications of economic profit use a capital asset pricing model (CAPM)−based cost of equity. The CAPM has been challenged as inadequately capturing the risk and return relationship (see Eugene F. Fama and Kenneth. R. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance 47, no. 2 (1992): 427−465.

33. Evidence suggests that economic profit is not a better predictor of future stock value than traditional measures. The primary challenge in using economic profit as a performance measure is estimating economic profit. See Jeffrey M. Bacidore, John A. Boquist, Todd T. Milbourn, and Anjan V. Thakor, “The Search for the Best Financial Performance Measure,” Financial Analysts Journal 53, no. 3 (1997): 11–20; and Pamela P. Peterson and David R. Peterson, Company Performance and Measures of Value Added (Charlottesville, VA: The Research Foundation of the Institute of Chartered Financial Analysts, 1996).

34. Richard Teitelbaum, “America's Greatest Wealth Creators,” Fortune, November 10, 1997: 265–276.