The Economic Margin (EM) Framework was developed by AFG 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.
MEASURING CORPORATE PERFORMANCE
AFG's Economic Margin (as opposed to accounting-based methods) has 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 a 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.
Traditional 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 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. AFG's Economic Margin can help investment managers clearly distinguish management teams ability to create shareholder value.
CALCULATING INTRINSIC VALUE
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.
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