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The Economic Margin framework is more than just a performance metric, as it encompasses a valuation system that explicitly addresses the four main value drivers of enterprise value: profitability, competition, growth, and cost of capital. Unlike traditional valuation approaches that utilize highly sensitive perpetuity assumptions, our approach incorporates the widely accepted economic principle that competition will compete away excess returns over time.
The Economic Margin framework explicitly models the effects of competition to gradually eliminate the excess spread a firm generates above or below its cost of capital (Economic Margin). Our research provides evidence of four factors that tend to explain the length of time that the market will pay for companies to generate returns above/below its cost of capital. For example, our research suggests that companies with high excess returns are likely to attract competition in the marketplace, requiring a shorter competitive advantage period in the company's valuation. Subtle insights such as these are just not achievable with traditional DCF approaches that rely on terminal values and perpetuities. Beyond being grounded in the widely accepted economic theories of Nobel Prize winners Merton Miller and Franco Modigliani, AFG’s valuation approach has a proven track record of consistently identifying companies trading above or below their intrinsic valuations across sectors, market capitalization groups, and growth/value universes.
AFG's Economic Margin goes beyond traditional accounting-based analysis, correcting for distortions created by differences in:
Capital Structure
In the end, the goal of any value-based metric is to remove these and other accounting distortions to provide comparability over time, firms, and industries. By comparing a firm's Operating Cash Flow to its true Cost of Capital, each adjusted to capture the nuances listed above, we can accurately measure the economic profitability or Economic Margin earned.
When doing a calculation of Economic Margin the numerator of the Economic Margin (similar to EVA), is based on economic profit, which helps focus managers on value creation. Unlike EVA, however, Economic Margin includes depreciation & amortization in cash flow and instead incorporates the return of capital explicitly in the capital charge. Economic Margin is based on gross assets, instead of net assets, which avoids the "Old Plant Trap" issues associated with EVA. Another distinction, unlike CFROI, Economic Margin’s cash flows are unlevered (i.e. all equity financed) and do not mix operating and financing decisions.
To learn more about the details of AFG's Economic Margin or for a free trial, click here
About Us | Contact Us | AFG is an Independent Equity Research Provider | In©2007 The Applied Finance Group
Economic Margin™ and Economic Margin Framework™ are trademarks of The Applied Finance Group, LTD. |
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