Profit Metrics - The Basics
Many marketers focus exclusively on the level or changes in revenues (sales volume) or market share. Bad
idea! While those are usually meaningful directional metrics, the ultimate performance focus must always be
on the bottom line – profitability.
Profitability can be measured in many ways.1 One metric is contribution margin 2 – the difference between
revenues and variable costs. When expressed on a unit basis, contribution margin is the difference between
price and variable costs per unit.
Net income (or operating income or earnings before taxes) is contribution margin less fixed costs. Profit
after taxes (PAT) is simply net income less taxes. Adding back non-cash expenses (e.g. depreciation)3 to
PAT gives operating cash flow.
In the example to the left, there are $100,000 in non-cash
expenses. For simplicity, assume that they are depreciation
– a legitimate P&L charge, but a non-cash item.
The $100,000 gets added back to PAT to get operating
cash flow.
Keeping in mind that it is ‘dollars’ that get deposited in the
bank, reinvested in the business, or distributed to
shareholders, absolute dollar levels are important.4
Often though, it is useful to state profitability as
a rate that relates the dollar level of profits to
the dollar level of some other relevant
measure.
For example, contribution margin % is simply
contribution margin (in dollars) divided by
revenue (sales).
Return on sales (ROS) is net income (or profit
after tax) divided by revenue (sales).
1
For simplicity, this note ignores financing considerations, and simply focuses on operating profitability.
2
Called “contribution” because it “contributes” towards fixed (or overhead) expenses.
3
There is a cash outflow at the time of investment, i.e. when an asset is acquired or, more precisely, when an asset is paid for;
depreciation is a non-cash flow accounting entry that attempts to reflect the actual usage of the asset in accordance with accounting’s
principle of matching revenues and costs as they occur.
4
DCF (discounted cash flows) is a measure that consolidates a stream of cash flows over time into a single number stated in current
dollars. In essence, DCF “discounts” future cash receipts (or disbursements) by the firm’s WACC (weighted average cost of capital).
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Profit Metrics - The Basics
These rates can be compared to other benchmarks (e.g. historical performance, other products in the
company’s line, industry norms) to calibrate whether performance is above or below “standard” or whether
trends are favorable or unfavorable.
Perhaps the most applicable profitability rate is return on
investment (ROI) which is profits (i.e. net income, PAT, or
OCF depending on the specific application) divided by the
investment required to generate those profits.5
At a minimum, ROI should exceed the company’s cost of
capital; otherwise, the company is losing money after
capital charges (e.g. interest payments).
More generally, ROI must be high relative to other
companies and other risk-adjusted investment
opportunities; otherwise, capital will flow away from the
company to more profitable options.
Economic value added (EVA) is a profit metric related to ROI.6 In essence, EVA is operating cash flow less
an estimated capital charge. In the example below, the annualized capital charge is the company’s
investment times its weighted average cost of capital ($2,500,000 x 10% = $250,000).
5
IRR (internal rate of return) is, in effect, the ROI for a stream of cash flows; ROA (return on assets) and ROE (return on equity) are
variants of ROI that are sometimes used in operations analysis (ROA) and financial analysis (ROE).
6
The appendix to this note provides additional conceptual background to EVA
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Profit Metrics - The Basics
Appendix – EVA & MVA
Economic Value Added (EVA) is a trademarked metric popularized in the 1990s by the Stern-Stewart
consulting group, though its roots are deep in traditional economics as ‘residual earning’, ‘economic profit’,
and ‘normal earnings’.
In essence, EVA is profits (net income, or profit after tax, or operation cash flow depending on the specific
application) adjusted to ’normalize’ the measure7, less an estimated capital charge – typically the company’s
WACC (weighted average cost of capital). So, EVA is a profit metric (expressed in dollars) that reflects the
financing costs associated with the investment required to generate the profits.
EVA is closely related to another performance metric: Market Value Added (MVA). In essence, MVA is the
market value of a firm (which can be thought of as roughly the number of shares outstanding times the
current share price) less the amount of capital invested in the firm: debt, common shareholder’s equity, and
retained earnings. The sum of the latter two components - CSE and retained earnings - is the firm’s
economic book value. So, MVA is the premium over economic book value that the market is currently pricing
into a stock.
7
For example, non-recurring earnings are deducted; large strategic investments are ‘smoothed’ in the accounting
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Profit Metrics - The Basics
Conceptually, MVA is the discounted present value of
the firm’s stream of EVAs.
Of course, MVA is impacted by overall market trends,
i.e. all stocks will be more likely to go up somewhat in
a rising market.
But, the relative difference is stock performance
appears to be directly related to EVA performance.
Specifically, empirical studies done by Stern-Stewart
indicate that about half of the variance in MVAs
across firms can be explained by differences in EVA
- a much higher proportion than can be attributed to
other common performance measures.
And, Stern Stewart concludes that each dollar of
EVA translates to roughly $9.50 in MVA.
Despite EVA’s classical theoretical roots, its intuitive appeal, and the supportive empirical evidence, it is
often criticized as discouraging growth and encouraging conservative business maintenance by:
•
Favoring big, low return businesses since they generate more profit dollars than smaller but
potentially higher return businesses (with commensurately smaller investment bases)
•
Favoring incremental investments that leverage existing an capital base, rather than more
substantial investments in new mega-initiatives
EVA supporters argue that these objections can be handled by ‘tweaking’ the EVA methodology and
applying some modicum of reasonable judgment. And, they argue that the EVA framework focuses attention
on improving returns on capital by:
•
Investing to grow profitable sales volume
•
Curtailing investment in underachieving businesses
•
Divesting / liquidating losing businesses
•
Optimizing the firm’s cost of capital
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