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

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1 CFROI as a Performance Metric: Issues Solved By AFG s Economic Margin 1

2 Basic Project Facts Capital 100 Life 10 Reinvestment %: 5% Cash Flow/Year 19 Discount Rate 10% Cash Flow Discount Factor Present Value Sum PV Investment NPV 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.

3 CFROI Overview Gross Investment: Total Assets + Acc. Dep. + Infl. Adj. GP. + Cap. Rentals +Cap. R&D Non-Debt Curr. Liabs. Cash Flow: Asset Life Net Income + DDA Expense + Int. BFIT + Rent + R&D ± Other Non- Depreciating Assets: Cash + Inventory + Other 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.

4 CFROI Overview Cash Flow: $19 Non-Depreciating Assets: $0 Gross Investment: $19 Asset Life: 10 years Cash Flow IRR: 13.77% True Cash IRR: 9.10% Error: 51% 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.

5 CFROI: Mixes Operating and Financing Decisions Company Unlevered Levered Unlevered Levered Sales Gross Plant Operating Expenses Acc. Dep Depreciation Net Plant Operating Income Total Assets Interest Expense PreTax Income Debt 0 80 Equity Income Tax (40%) Net Income Total Liab & Equity Company Unlevered Levered Net Income DDA Interest Expense Cash Flow Gross Investment Life CFROI 13.77% 16.71% ROE 10.0% 56.4% Because CFROI does not separate the effects of financing from operations, it is easily distorted by firms that change their capital structure. By increasing its leverage in this example, the firm is able to increase its calculated CFROI by over 20%. This is similar the distortions inherent to an ROE measure, and another reason why CFROI can lead a money manager to false conclusions about the performance of a company.

6 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

7 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.

8 Economic Margin Calculation Details Operations Based Cash Flow: + Net Income + Depreciation & amortization + After Tax Interest Expense + Rental Expense Net Int. Adj. + R & D Expense ± Non-Recurring Items Capital Charge: Return on and Return of Capital that captures company specific economic circumstances. Inflation Adjusted Invested Capital: + Total Assets + Accumulated Depreciation + Gross Plant Inflation Adjustment + Capitalized Operating Rentals + Capitalized R & D - Non Debt Current Liabilities

9 AFG s Capital Charge The True Capital Charge Given 5% W ACC, W hat Must Project Yield To Break Even? N i = 5 Investment: $10,000 PV FV Life = 10 years N Annual Economic Charge = $898 PMT =? Salvage: $5000 0% 50% 100% 7 $1,728 $1,114 $500 $1,295 $1,065 $898 $728 FV $500 $500 AFG s Capital Charge correctly adjusts for each company s asset life and mix characteristics to provide the correct cost of wealth creation across industries. Notice there are no reinvestment assumptions such as those inherent to the CFROI calculation, that distort AFG s Economic Margin from reflecting a company s true performance.

10 Economic Margin: Properly Separates Operating and Financing Decisions Company Unlevered Levered Unlevered Levered Sales Gross Plant Operating Expenses Acc. Dep Depreciation Net Plant Operating Income Total Assets Interest Expense PreTax Income Debt 0 80 Equity Income Tax (40%) Net Income Total Liab & Equity Company Unlevered Levered Net Income DDA After Tax Interest Expense Cash Flow Gross Investment Capital Charge EM 2.73% 2.73% Unlike the CFROI calculation, AFG s Economic Margin properly separates the effects of financing and operating decisions. Notice that regardless of how the project is financed, AFG s Economic Margin properly focuses on and captures the operating returns of the firm and is not distorted by how those operations are financed.

11 Economic Margin Framework Linking Performance to Value 6 Price/ Earnings R 2 = Near 0 Data: S&P 500 Market Value/ Invested Capital ( MVIC ) R 2 = Data: S&P Earnings Growth Successful companies measure results, make decisions and set strategy with the goal of creating value. A company s performance measures must serve 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 Economic Margin % Economic Margin is a more complete performance measure for companies to use to guide performance and motivate employees. Executives consider Cash Flow, Investment, Competition & Risk when setting strategy. The above charts show that investors do the same.

12 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

13 MV/IC Economic Performance & Equity Selection Changes in Economic Performance Leads to Changes in Market Performance Economic Margin Theory: Changing EM Levels lead to changes in market multiples. The market rewarded and punished improvements/declines in economic performance Fact: 3% Annual Return for Portfolios Formed on Forecast EM Change versus Entire Universe (3/96-12/03) Companies with expected EM improvement outperform those with expected declines by over 540 BP annually. 2% 1% 0% -1% -2% 2.68% -2.75% -3% Top 50% EM Change Bottom 50% EM Change Source: AFGView client databases from 4/96 to 12/30/03 Universe size: 4,000 to 5,500 firms

14 Economic Margin Framework Economic Performance and Corporate Strategy + Economic Margin 0 - Wealth Destroying Business Break-Even Business Wealth Creating Business Strategy Earn right to invest; Divest losers; Identify core competencies Focus on Profitability and Efficiency; Growth is irrelevant Grow the Business, to capture positive NPV opportunities

15 Economic Margin Framework Economic Performance and Corporate Strategy 6% 4% 2% 0% -2% -4% -6% -8% -10% Annual Return Spreads vs. Universe of Firms Growing Assets at least 10% Annually (10/96-12/03) 4.55% Positive EM & Investing -7.45% Negative EM & Investing Theory: Firms earning less than their cost of capital should focus on improving core businesses and divesting losers, while those with positive EM s need to deliver growth to capture NPV positive opportunities. 1% 0% -1% Annual Return Spreads vs. Universe of Firms Divesting Assets at least 10% Annually (10/96-12/03) 0.09% -2.03% Fact: Firms expected to follow wealth creating strategies outperform those that do not by up to 1200 BP annually from 10/96 through 12/03. The market rewards economic wealth creation. -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

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