“Frequently, the maximization of economic profits is in direct conflict with the maximization of immediate accounting profits.” This line is from Martin Whitman’s classic The Aggressive Conservative Investor. When we consider company press releases regarding earnings, it is the always earnings or earnings per share that is most often cited. This measure is reported as GAAP (generally accepted accounting principles) net income divided by shares outstanding. This familiar number is considered to be accounting profit as it conforms to the standard reporting format for all U.S. firms. However, actual economic profit is never considered. This revelation may seem confusing. Isn’t profit, well, profit? Not necessarily. The biggest difference between the two is simply that accounting can be manipulated, value creation cannot.
The real question is; how do we define true economic profit? We tend to think of economic profit as that which creates shareholder value - any excess profit earned above a firm’s cost of capital. At the heart of this economic value is the notion that corporate managers pursue projects that produce the largest spread between the initial cash investment and the present value of ensuing cash flows. The only way for firms to create value is to sustain excess profits above all capital charges. This is also known as a competitive advantage. As one might imagine, this is very difficult to do - especially for long periods of time. Very few firms succeed at generating true economic profit for long periods of time. Perhaps the best example of this concept is Microsoft. Exploiting the unique competitive advantage of the Windows operating system generated tons of economic profit.
Why the discrepancy between accounting and economic profit? The biggest factor is that firms often destroy value by earning profits below the cost of capital invested. Capital intensive firms such as heavy manufacturers may book accounting profits, but the required capital to maintain proper infrastructure is so high that all profits generated are redeployed rather than retained in earnings. Think of this simple example. Suppose you start a business and need start-up capital of $100,000. You pay 9% interest on the $100,000 with annual borrowing cost of $9,000. The business generates $100,000 in annual revenue, but profits after all expenses are only $8,000. So even though the business is running a profit, it’s just destroyed $1,000 worth of value. Furthermore, a capital charge for equity capital is completely absent from the calculation.
There are other factors which make accounting profits difficult to interpret. This is because income and expenses are recorded on an accrual basis. That is, actual cash flows may not match perfectly against reported earnings. Accruals are a normal business practice and may arise from changes in working capital (receivables and inventories), deferred taxes, or payables. However, when accruals diverge from cash flows over time this may be problematic. Understanding a company’s cash flow provides more clarity.
Unfortunately, the only figure discussed in the mainstream media is the bottom line earnings per share. It’s the quickest and easiest number to present. Furthermore, Wall Street (including large institutional investors) is obsessed with quarterly earnings as well. It’s not surprising that corporate managers are quick to reference accounting earnings, rather than actual value created. Yet there is so much more that goes into how firms actually create value. We have only scratched the surface on this topic. Yes - I realize that it’s convenient to focus on this one figure, but for those willing to go beyond accounting to seek the true economic picture, the results may be astounding.
The real question is; how do we define true economic profit? We tend to think of economic profit as that which creates shareholder value - any excess profit earned above a firm’s cost of capital. At the heart of this economic value is the notion that corporate managers pursue projects that produce the largest spread between the initial cash investment and the present value of ensuing cash flows. The only way for firms to create value is to sustain excess profits above all capital charges. This is also known as a competitive advantage. As one might imagine, this is very difficult to do - especially for long periods of time. Very few firms succeed at generating true economic profit for long periods of time. Perhaps the best example of this concept is Microsoft. Exploiting the unique competitive advantage of the Windows operating system generated tons of economic profit.
Why the discrepancy between accounting and economic profit? The biggest factor is that firms often destroy value by earning profits below the cost of capital invested. Capital intensive firms such as heavy manufacturers may book accounting profits, but the required capital to maintain proper infrastructure is so high that all profits generated are redeployed rather than retained in earnings. Think of this simple example. Suppose you start a business and need start-up capital of $100,000. You pay 9% interest on the $100,000 with annual borrowing cost of $9,000. The business generates $100,000 in annual revenue, but profits after all expenses are only $8,000. So even though the business is running a profit, it’s just destroyed $1,000 worth of value. Furthermore, a capital charge for equity capital is completely absent from the calculation.
There are other factors which make accounting profits difficult to interpret. This is because income and expenses are recorded on an accrual basis. That is, actual cash flows may not match perfectly against reported earnings. Accruals are a normal business practice and may arise from changes in working capital (receivables and inventories), deferred taxes, or payables. However, when accruals diverge from cash flows over time this may be problematic. Understanding a company’s cash flow provides more clarity.
Unfortunately, the only figure discussed in the mainstream media is the bottom line earnings per share. It’s the quickest and easiest number to present. Furthermore, Wall Street (including large institutional investors) is obsessed with quarterly earnings as well. It’s not surprising that corporate managers are quick to reference accounting earnings, rather than actual value created. Yet there is so much more that goes into how firms actually create value. We have only scratched the surface on this topic. Yes - I realize that it’s convenient to focus on this one figure, but for those willing to go beyond accounting to seek the true economic picture, the results may be astounding.
