Adjusted economic margin

Adjusted Economic Margin: Definition, Formula, Example, and FAQs

Adjusted Economic Margin (EM) is a proprietary financial performance metric that evaluates a company's economic profitability by measuring its ability to generate cash flow in excess of its total capital costs. This metric belongs to the broader category of financial performance metrics and is a key component within value-based management frameworks, aiming to provide a more accurate picture of true wealth creation. It corrects for various accounting distortions often found in traditional financial reporting.

History and Origin

The Adjusted Economic Margin framework was developed by the Applied Finance Group (AFG) to evaluate corporate performance from an economic cash flow perspective, serving as an alternative to purely accounting-based metrics. It was designed to overcome some limitations found in other economic profit measures like Economic Value Added (EVA) and Cash Flow Return on Investment (CFROI). The goal of EM is to measure the return a company earns above or below its cost of capital and offer a more complete view of a company's underlying economic vitality. A white paper outlining the Economic Margin Valuation™ framework was included in the 2000 book "Value-Based Metrics: Foundations and Practice" by Frank J. Fabozzi and James L. Grant.

²⁶## Key Takeaways

• Adjusted Economic Margin quantifies whether a company is creating or destroying shareholder value by comparing its operational cash flow to the cost of capital employed.
• It is designed to remove various accounting distortions, offering a more comparable measure of performance across different companies, industries, and time periods.
• Unlike some traditional metrics, Adjusted Economic Margin explicitly accounts for the time value of money and the true economic cost of assets.
• A positive Adjusted Economic Margin indicates that a company is generating cash flow in excess of the costs associated with its invested capital, suggesting value creation.
• The metric helps management and investors focus on long-term economic profit rather than short-term accounting profits.

Formula and Calculation

The Adjusted Economic Margin is calculated as follows:

Where:

• Operating Cash Flow: Represents the cash generated from a company's core operations, often adjusted to remove non-cash expenses like depreciation and amortization, and to account for changes in working capital. This aims to capture all the cash generated by a firm's capital base.,
  ²⁵*²⁴ Capital Charge: This is the dollar cost of the capital employed by the company, essentially the minimum cash flow required to compensate investors for the riskiness of the business given the amount of invested capital. It explicitly incorporates the return of capital.
  *²³ Invested Capital: The total amount of money, from both debt and equity, that has been invested in the company's operating assets. For Adjusted Economic Margin, this is typically based on gross assets, which helps to avoid distortions related to asset age.,
  ^{22
  21}The formulation emphasizes that the numerator, like EVA, is based on economic profit, helping to focus managers on value creation.

²⁰## Interpreting the Adjusted Economic Margin

Interpreting the Adjusted Economic Margin involves assessing whether the percentage is positive or negative, and how it compares to industry peers or the company's historical performance. A positive Adjusted Economic Margin signifies that the company's operations are generating returns above its cost of capital, indicating that it is creating economic value. Conversely, a negative Adjusted Economic Margin suggests that the company is destroying value, as its returns are not sufficient to cover the cost of the capital employed.

The metric's percentage format allows for direct comparison across companies of different sizes and industries, providing a consistent basis for evaluation. U¹⁹nlike dollar-based economic profit measures, this ratio provides insights into the efficiency with which a company uses its assets to generate returns beyond its cost of funding. It helps analysts evaluate how well management teams allocate resources and generate returns from their asset management strategies.

Hypothetical Example

Consider "Company Alpha," a manufacturing firm.

Year 1 Financial Data:

• Operating Cash Flow: $1,500,000
• Invested Capital: $10,000,000
• Cost of Capital (WACC): 8%

To calculate the capital charge:
Capital Charge = Invested Capital × Cost of Capital = $10,000,000 × 0.08 = $800,000

Now, calculate the Adjusted Economic Margin:

In this scenario, Company Alpha has an Adjusted Economic Margin of 7%. This positive percentage indicates that Company Alpha is generating a return of 7% above its cost of capital for every dollar of invested capital, thereby creating value for its stakeholders.

Practical Applications

Adjusted Economic Margin serves several practical applications in corporate finance and investment analysis:

• Performance Measurement: Companies can use Adjusted Economic Margin to gauge internal performance, identify business units that are creating or destroying value, and hold managers accountable for capital utilization. It encourages a focus on generating returns that exceed the weighted average cost of capital.
• Capital Allocation: By providing a clear measure of economic profitability, Adjusted Economic Margin aids in strategic decision-making regarding capital allocation for new projects, expansions, or divestitures. Firms can direct resources towards ventures with higher potential for economic value creation.
• Investment Analysis: Investors and analysts utilize this metric to compare the true economic performance of different companies, transcending superficial accounting differences. It helps in identifying companies that are genuinely productive and creating long-term enterprise value.
• Executive Compensation: Aligning executive incentives with Adjusted Economic Margin can encourage management to make decisions that truly enhance shareholder wealth, rather than just boosting reported earnings. McKinsey & Company emphasizes that long-term value creation requires companies to grow and earn returns above their cost of capital in a sustainable way.,

I¹⁸t¹⁷ is important for public companies to consider the guidance provided by the U.S. Securities and Exchange Commission (SEC) on the use of non-GAAP financial measures, such as Adjusted Economic Margin, in their public disclosures. The SEC mandates that such measures must be reconciled to the most directly comparable generally accepted accounting principles (GAAP) measure and not be misleading., Th¹⁶e¹⁵ Federal Reserve Bank of St. Louis's FRED database provides various corporate profit metrics with adjustments that can be considered when analyzing economic performance.

##¹⁴ Limitations and Criticisms

While Adjusted Economic Margin offers a robust view of economic profitability, it is not without limitations. A primary criticism, common to many adjusted financial metrics, is the potential for subjectivity in the numerous adjustments made to raw accounting data. While the aim is to remove distortions and provide comparability, the specific adjustments for factors like asset age, asset mix, and off-balance-sheet assets and liabilities can be complex and may vary, potentially impacting comparability across different analyses.

Fu¹³rthermore, the calculation of operating cash flow and invested capital for the Adjusted Economic Margin requires detailed financial data and a deep understanding of the underlying adjustments. This complexity can make it challenging for external stakeholders to replicate or fully scrutinize the figures without access to proprietary methodologies. Despite its aim to avoid the "old plant trap" (where older, depreciated assets can artificially boost accounting-based returns), its reliance on gross assets still requires careful handling.

Li¹²ke other non-GAAP financial measures, the Adjusted Economic Margin is subject to scrutiny by regulatory bodies such as the SEC. The SEC's guidance, updated over time, emphasizes that non-GAAP measures should not be presented in a misleading way and must be accompanied by reconciliations to their GAAP equivalents. Adj¹¹ustments that exclude normal, recurring operating expenses could be deemed misleading.

##¹⁰ Adjusted Economic Margin vs. Economic Value Added (EVA)

Adjusted Economic Margin and Economic Value Added (EVA) are both profitability ratios that fall under the umbrella of economic profit measures, aiming to determine if a company is truly creating wealth beyond its cost of capital. However, key differences distinguish them.

EVA, developed by Stern Value Management, is calculated as net operating profit after taxes (NOPAT) minus a capital charge (Invested Capital × Weighted Average Cost of Capital)., It i⁹s a dollar-denominated measure, representing the absolute amount of residual wealth.,

Adjusted Economic Margin, on the other hand, is a percentage-based metric. While both metrics incorporate a capital charge, a key distinction lies in how they treat capital and depreciation. Adjusted Economic Margin adds depreciation and amortization back to cash flow and explicitly incorporates the return of capital in its capital charge calculation. Cruc⁸ially, it uses gross assets as its capital base, similar to CFROI, which helps to avoid the "old plant trap" where net asset-based measures can be distorted by the age of assets., EVA^{7 6}typically uses net assets, which can disincentivize new investment or distort comparisons over time due to depreciation. Adju⁵sted Economic Margin also seeks to remove more extensive accounting distortions than a basic EVA calculation, aiming for greater comparability.

⁴FAQs

What does a positive Adjusted Economic Margin indicate?

A positive Adjusted Economic Margin indicates that a company's operations are generating cash flow in excess of the capital costs required to fund its assets. This suggests that the company is creating economic value and enhancing shareholder value.

Why is it "adjusted"?

The term "adjusted" refers to the comprehensive modifications made to traditional accounting figures (like revenue, expenses, and assets) to better reflect the true economic reality of a business. These adjustments aim to remove distortions caused by GAAP accounting rules, making the metric more comparable across companies and industries.

Is Adjusted Economic Margin a GAAP measure?

No, Adjusted Economic Margin is a non-GAAP financial measure. It is a proprietary metric that deviates from standard accounting principles to provide a different perspective on profitability and value creation. Public companies disclosing such measures are subject to SEC regulations requiring reconciliation to comparable GAAP figures.,

##³#² How does it differ from traditional profit margins?

Traditional profit margins (like gross profit margin, operating profit margin, or net profit margin) are based solely on accounting profits and revenues. They¹ do not explicitly account for the cost of the capital employed to generate those profits. Adjusted Economic Margin, conversely, deducts a comprehensive capital charge, reflecting the true economic cost of both debt and equity capital, thereby measuring economic profit rather than just accounting profit.