The challenge is to find a measure of business performance that correlates with share price movements. Then, if we plan our business to raise this measure, we should raise the share price, and hence create value for our shareholders.
EBITDA
Earnings before interest, tax, depreciation and amortisation (EBITDA)
Profit is not a good measure of the value a business is generating for its shareholders. Ultimately, a shareholder is interested in the amount of cash generated, rather than profit (which is after all only an accounting calculation). It is cash which enables the business to expand and develop, and pay dividends. And it is the expectation of future cash flows that drives the share price up, and creates values for shareholders.
In calculating profit, depreciation is included as a cost.
Depreciation and amortisation are not cash transactions but an accounting exercise to balance the reducing value of assets over time. We can measure earnings before interest, tax, depreciation and amortisation - EBITDA! This is the amount of operating profit that will eventually be turned into cash. But EBITDA alone doesn't tell us if we are creating value.
Economic profit or Economic Value Added (EVA)
Economic profit (EP) takes account of the fact that investors have choices. They can invest in your company, or your competitor; in art; in another industry; or put their money in the bank. Every investment has a certain amount of risk, and a level of reward.
If your company generates more cash for each pound invested than other investments with a similar level of risk, it is making an 'economic profit'.
- Studies of real companies show clearly that an increase in EP correlates strongly with an increase in share price, and the creation of shareholder value.
- A fall in EP goes with a reduction in share price, and destruction of shareholder value.
Economic profit is calculated by taking the cash flow generated by the business (EBITDA) and subtracting a 'charge' for the 'cost of capital'. The cost of capital is the profit the business must make, simply to meet the expectations of investors who take this level of risk.
If the company was financed only by shareholders' funds, the cost of capital would be the average return of investments after tax with the same level of risk; for example, a group of companies of similar size in the same industry. This is the 'cost of equity'.
Most companies are financed partly by shareholders' funds, and partly by bank loans. So, their cost of capital is not simply the cost of equity, but takes into account the interest paid on loans as well. This is known as the 'weighted average cost of capital', or the WACC rate.
Economic profit is calculated by
- subtracting a capital charge (the net asset value of a business multiplied by the WACC rate) from EBITDA.
- Tax is also deducted because this is paid out of cash flow.
- Interest is not deducted, as the capital charge has already taken this into account.
Economic profit = Profit (Earnings) - Tax - Capital charge
Capital charge = Net Asset Value of a business X WACC rate
Example of application of Economic Profit
http://spreadsheets.google.com/pub?key=t7BiKoYpNh8QNDvzcZoN8xA&output=html
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