Economic Margin

Calculation of a competition-adjusted corporate performance. Explanation of Economic Margin.

The Economic Margin framework of Daniel J. Obrycki and Rafael Resendes can be used to calculate a competition-adjusted corporate performance.

Economic cash flow perspective

The Economic Margin (EM) framework was developed to evaluate corporate performance from an economic cash flow perspective. EM goes beyond traditional accounting-based analysis. It corrects for distortions that were caused by the following differences: capital structure, asset age, asset life, asset mix, off-balance-sheet assets and liabilities, and the investment which is needed to generate earnings and cost of capital.

Economic Margin

Valuation system with four drivers

The Economic Margin Framework is more than just a performance measurement, as it encompasses a valuation system, that explicitly contains four main value drivers of corporate performance and enterprise value:

profitability,
competition,
growth, and
cost of capital.

Economic Margin and DCF

Companies with high excess returns are likely to attract competitors in the marketplace. This will lead to a shorter competitive advantage period in the company's valuation. Traditional Discounted Cash Flow approaches rely on terminal values and perpetuities. Unlike such traditional valuation approaches that utilize highly sensitive eternity assumptions, the Economic Margin approach can use the following widely accepted economic principle: that over time its competitors will compete away excess returns. The EM Framework thus explicitly models the effects of competition to gradually eliminate the excess margin which a firm generates above or below its cost of capital (Economic Margin).

Roots of Economic Margin framework

The Economic Margin framework is grounded in the widely agreed theories of Nobel price winning Merton Miller and Franco Modigliani. EM can help to identify companies trading above or below their intrinsic valuations. Across sectors and market capitalization groups and growth/value universes.

EM, EVA and CFROI

When one is calculating Economic Margin, one has to bear in mind that the numerator of the Economic Margin (like EVA), is based on economic profit. This helps managers focus on value creation. Unlike EVA, however, Economic Margin adds depreciation and amortization to cash flow and instead incorporates the return on capital explicitly in the capital charge. Also (like CFROI), Economic Margin is based on gross assets, which helps to avoid the growth "disincentive" typically associated with net asset based measures. Unlike CFROI, however, the Economic Margin's cash flows are not leveraged (i.e. all equity financed). Also, EM cash flows treat operational decisions and financing decisions in a separate way.