CFROI as a Performance Metric: Issues ... - Economic Margin

CFROI as a Performance Metric:
Issues Solved By AFG’s Economic Margin

1

Basic Project Facts

Capital 100 Cash Flow/Year 19
Discount Rate 10%
Life 10

Reinvestment %: 5%

Cash Flow 1 2 3 4 5 6 7 8 9 10
Discount Factor
Present Value 19 19 19 19 19 19 19 19 19 19
1.10 1.21 1.33 1.46 1.61 1.77 1.95 2.14 2.36 2.59
Sum PV 17.27 15.70 14.27 12.98 11.80 10.73 9.75 8.86 8.06 7.33
Investment
NPV 116.75
100.00
16.75

We will start with this basic project to examine how well CFROI links to reality. Notice
how the true performance of the project remains constant each and every year. It
generates $19 of cash flow, but can only reinvest those cash flows in future projects
that only generate 5%. A useful metric must reflect that the project’s performance is
not changing over time, and will not be distorted by the lower reinvestment
opportunities available to investors.

CFROI Overview

Cash Flow: Net Income

+ DDA Expense Non-
+ Int. BFIT Depreciating
+ Rent Assets:
+ R&D
± Other Cash
+ Inventory
+ Other

Gross Investment: Asset Life

Total Assets
+ Acc. Dep.
+ Infl. Adj. GP.
+ Cap. Rentals
+Cap. R&D
– Non-Debt Curr. Liabs.

The figure above lays out the basic structure of a CFROI calculation. The basic components are:

Gross Investment Asset Life

Annual Cash Flow Non-Depreciating Assets

Notice that this is essentially an IRR calculation, which fundamentally assumes that all cash flows
will be reinvested at the IRR. This is not a realistic assumption and significantly distorts the ability

of CFROI to accurately model a company’s true return. This is clearly illustrated on the next
page using the information from our initial example.

CFROI Overview

Cash Flow: $19 Non-Depreciating
Assets: $0

Asset Life: Cash Flow IRR: 13.77%
10 years
True Cash IRR: 9.10%
Gross Error: 51%
Investment: $19

In this example, it is easy to see that as a result of assuming all cash flows are reinvested at the
calculated IRR, rather than the rate at which they can actually be reinvested, a Cash Flow IRR

measure has significant amount of error. In this example, the true return to this project is
approximately 9.1%, not the 14% generated by the naive assumptions of an IRR model.

CFROI: Mixes Operating and Financing Decisions

Company Unlevered Levered Unlevered Levered

Sales 95 95 Gross Plant 100 100
Operating Expenses 70 70 Acc. Dep. 10 10
Depreciation 10 10 Net Plant 90 90

Operating Income 15 15 Total Assets 90 90

Interest Expense 0 5.6

PreTax Income 15 9.4 Debt 0 80
Equity 90 10

Income Tax (40%) 6 3.76

Net Income 9 5.64 Total Liab & Equity 90 90

Company Unlevered Levered

Net Income 9 5.64 Because CFROI does not separate the effects of
DDA 10 10 financing from operations, it is easily distorted by
Interest Expense 0 5.6 firms that change their capital structure. By
Cash Flow increasing its leverage in this example, the firm is
19 21.24 able to increase its calculated CFROI by over 20%.
Gross Investment This is similar the distortions inherent to an ROE
100 100 measure, and another reason why CFROI can lead a
Life money manager to false conclusions about the
10 10 performance of a company.
CFROI
13.77% 16.71%
ROE
10.0% 56.4%

AFG’s Economic Margin Addresses Equity
Analysis Basics

• Evaluating an investment requires answers to three questions:
– How much capital is required?
– What is the cash flow?
– What are the opportunity costs of capital?

• AFG’s Economic Margin Framework addresses each of these issues in a systematic manner
that corrects the distortions inherent to as reported accounting data

AFG’s Economic Margin Calculation:

EM = Operating Cash Flow - Capital Charge
Invested Capital

AFG’s Economic Margin Framework is unlike any other performance
metric available to investment professionals. Unlike EVA, Economic
Margin is driven by operational cash flow that leads to an accurate
valuation approach. Also, unlike CFROI, Economic Margin is not
driven by simplistic and unrealistic IRR assumptions.
In essence, Economic Margin is a blend of the operating cash flow basis
of a CFROI, with the economic profit basis of EVA. The end result is a
metric that accurately realistically captures a firm’s true economic
performance and consistently and successfully links to market valuations.

Economic Margin Calculation Details

Operations Based Cash Flow: Capital Charge:
+ Net Income
Return on and Return of Capital
+ Depreciation & amortization that captures company specific
+ After Tax Interest Expense economic circumstances.
+ Rental Expense Net Int. Adj.
+ R & D Expense
± Non-Recurring Items

Inflation Adjusted Invested Capital:
+ Total Assets

+ Accumulated Depreciation
+ Gross Plant Inflation Adjustment
+ Capitalized Operating Rentals
+ Capitalized R & D
- Non Debt Current Liabilities

AFG’s Capital Charge – The True Capital
Charge

G iven 5% W A C C , W h at M u st P ro ject Y ield To B reak E ven?

i= 5 S alvage: AFG’s Capital Charge
$5000 correctly adjusts for each
FV company’s asset life and
mix characteristics to
L ife = 10 years provide the correct cost of
N wealth creation across
industries.
In vestm en t: PMT = ?
$ 1 0 ,0 0 0 Notice there are no
PV reinvestment assumptions
such as those inherent to
A n n u al E co n o m ic C h arg e = $898 the CFROI calculation,
that distort AFG’s
N FV 0 % 50% 100% Economic Margin from
$ 1 ,1 1 4 $500 reflecting a company’s
7 $ 1 ,7 2 8 $500 true performance.
1 0 $ 1 ,2 9 5 $898 $500
1 3 $ 1 ,0 6 5 $728

Economic Margin: Properly Separates
Operating and Financing Decisions

Company Unlevered Levered Unlevered Levered

Sales 95 95 Gross Plant 100 100
Operating Expenses 70 70 Acc. Dep. 10 10
Depreciation 10 10 Net Plant 90 90

Operating Income 15 15 Total Assets 90 90

Interest Expense 0 5.6

PreTax Income 15 9.4 Debt 0 80
Equity 90 10

Income Tax (40%) 6 3.76

Net Income 9 5.64 Total Liab & Equity 90 90

Company Unlevered Levered

Net Income 9 5.64 Unlike the CFROI calculation, AFG’s
DDA 10 10 Economic Margin properly separates the
After Tax Interest Expense 0 3.36 effects of financing and operating
Cash Flow 19 19 decisions. Notice that regardless of how
the project is financed, AFG’s Economic
Gross Investment 100 100 Margin properly focuses on and captures
the operating returns of the firm and is
Capital Charge 16.27 16.27 not distorted by how those operations
are financed.
EM 2.73% 2.73%

Economic Margin Framework

Linking Performance to Value

Price/ 100 R2 = Near 0 6 R2 = .61
Earnings 80
60 Data: S&P 500 Market Value/ 5
Invested Capital

(“MVIC”) 4

3

2

-100 -50 0 50 100 150 200 250 300 1

Earnings Growth 0 Data: S&P 500

-15 -10 -5 0 5 10 15 20 25

Economic Margin %

Successful companies measure results, make decisions and set strategy with Economic Margin is a more complete performance measure for companies
the goal of creating value. A company’s performance measures must serve to use to guide performance and motivate employees. Executives consider
as a proxy for its market value creation. While important, S-T Earnings alone
are a poor indicator of a company’s value, due to what they do not measure. Cash Flow, Investment, Competition & Risk when setting strategy. The
above charts show that investors do the same.

Economic Margin Framework

AFG’s Equity Analysis Framework:

Evaluating Corporate Performance

1. Focus the analysis process on understanding current and
expected levels of economic performance:
Invest in improving EM companies.

2. When evaluating companies, ensure that their strategy lines
up with their economic performance:

Positive EM companies must invest
Negative EM companies must divest

Economic Performance & Equity Selection

Changes in Economic Performance Leads to
Changes in Market Performance

6 Theory:

5 Changing EM Levels lead to changes
in market multiples.
MV/IC 4
3 The market rewarded and punished
improvements/declines in economic
2 performance

1
-15 -10 -5 00 5 10 15 20 25

Economic
Margin

Fact: Annual Return for Portfolios Formed on Forecast EM

Companies with expected EM Change versus Entire Universe (3/96 - 12/03)
improvement outperform those with
expected declines by over 540 BP 3%
annually.
2%

1% 2.68%

0%

-1% -2.75%

-2%

-3% Bottom 50% EM Change
Top 50% EM Change

Source: AFGView client databases from 4/96 to 12/30/03
Universe size: 4,000 to 5,500 firms

Economic Margin Framework

Economic Performance and Corporate Strategy

+

Economic 0
Margin

-

Wealth Destroying Break-Even Wealth Creating
Business Business Business

Strategy • Earn right to invest; • Focus on • Grow the
Divest losers;
Identify core Profitability and Business, to
competencies
Efficiency; Growth capture positive
NPV opportunities
is irrelevant

Economic Margin Framework

Economic Performance and Corporate Strategy

6% Annual Return Spreads vs. Universe of Firms Growing Theory:
4% Assets at least 10% Annually (10/96 - 12/03) Firms earning less than their cost of
2% 4.55% capital should focus on improving core
0% businesses and divesting losers, while
-2% -7.45% those with positive EM’s need to deliver
-4% growth to capture NPV positive
-6% opportunities.
-8%
-10%

Positive EM & Investing Negative EM & Investing

Annual Return Spreads vs. Universe of Firms Divesting Fact:
Assets at least 10% Annually (10/96 - 12/03) Firms expected to follow wealth creating
strategies outperform those that do not by
1% up to 1200 BP annually from 10/96
0.09% through 12/03. The market rewards
economic wealth creation.
0%

-1% -2.03%

-2% Negative EM & Divesting Positive EM & Divesting

Source: AFGView client databases from 10/96 to 12/03
Universe size: 4,000 to 5,500 firms