It’s hard to overstate the importance of separating incentive targets from budgets to avoid “sandbagging”-the tendency to lowball expectations to boost one’s bonus. And any future payoffs from investments won’t weigh much in the balance either, since by the time they materialize, they will also be included in the budget. When comp targets are set equal to budgets, it leads to continued spending on failing projects, since the waste is already “baked” into the budget and won’t affect management’s bonus. This removes the incentive to cut R&D to meet short-term earnings while increasing the incentive to reallocate R&D spending away from failing projects and toward those that are more promising.Īnother crucial opportunity for improving typical EP implementations is to delink incentive targets from plans or budget targets. To address this, our approach adds back these expenses, and capitalizes them over an appropriate period. One executive recently pointed out how this helped orient the firm towards a “growth mindset” and “away from the silo behavior that resulted from our past focus on efficiency.”Ī second barrier to long-term value creation is GAAP’s insistence on expensing corporate investments in intangible assets like R&D and brand building, which penalizes these important long-run value drivers. The total cost of new assets is lower, without depreciations, and the capital charge doesn’t decline over time, so we avoid the illusion of value creation as the asset depreciates away. To address potential underinvestment, we at Fortuna Advisors make adjustments to conventional EP by using undepreciated assets and not charging depreciation to earnings. As one CFO recently put it, “EVA loves old assets.” But our research suggests that EP companies are not afraid to put growth resources to work when they have sufficient margins to cover capital costs.Īs for the lower growth, this finding reinforces a long-standing criticism of generic EP (and EVA)-which depreciates fixed assets, making new investments seem more expensive than depreciated assets. Critics of EP argue that putting a charge on capital stifles growth. This under performance on asset intensity, though unexpected, was reassuring in one sense. But in our 2023 Fortuna Advisors Value Leadership Report, various measures of profit margin and capital productivity related better to TSR than revenue growth over the five years ending in 2022-signaling a shift in investor attitudes.ĭespite the clear outperformance of EP companies in our study, EP companies had lower revenue growth and were more asset intensive. Our research at Fortuna Advisors indicates investors had a clear preference for growth over margins and returns on capital during the five years ending in 2021-a period of unusually low interest rates. EP is suitable for identifying value creation opportunities because it clarifies tradeoffs in various measures in one complete and balanced metric. There are various forms of EP, the most well-known being economic value added (EVA) but all deduct a capital charge from profit or cash flow for the use of invested assets. Because of this, EP is often used to guide processes from planning and resource allocation to executive rewards. ![]() Company-wide adoption generally leads to better results and an investor-oriented culture, while maintaining accountability for results over multiple time periods. Given this linkage, EP can function as the centerpiece of financial management to encourage owner-like thinking and decision-making. Given this outperformance, more companies-and their shareholders-would benefit from using EP.Ĭomplete Measurement and Linkage to Shareholder ReturnsĬompanies embrace EP for many reasons, but at the top of the list is how well it correlates with shareholder value. ![]() What’s more, their EBITDA margins were 3% higher, and their increases in EBITDA margin were 0.8% larger. These EP companies outperformed their peers on total shareholder return (TSR) by an average of 4.7% per year, beating the S&P 500 by 7.0%. ![]() In a recent study my colleagues and I identified over 30 public companies that use EP in incentive plans. NASDAQ’s CEO, Adena Friedman, said it well when she wrote on LinkedIn, “In an environment where money is no longer free, there will be a shift away from the pursuit of growth at all costs.” To make better decisions in this environment, companies should consider using economic profit-“EP” for short. To bring it down, the Fed is raising interest rates, which has forced corporate leaders to be more discerning about where and how they invest in growth. Inflation has subsided some, but it’s still far above the last few decades.
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