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Calculating Competition-adjusted Corporate Performance

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Economic Margin

Summary of the EM Model by Obrycki and Resendes

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Daniel J. Obrycki, Rafael Resendes (1996)

Applied Finance Group

Economic MarginThe Economic Margin model of Daniel J. Obrycki and Rafael Resendes can be used to calculate competition-adjusted corporate performance.
 

The EM Framework was developed to evaluate corporate performance from an economic cash flow perspective. The metric goes beyond traditional accounting-based analysis, correcting for distortions created by differences in Capital Structure, Asset Age, Asset Life, Asset Mix, Off Balance Sheet Assets and Liabilities, Investment Needed to Generate Earnings and Cost of Capital.


EM is more than just a performance metric, as it encompasses a valuation system that explicitly addresses four main value drivers of corporate performance and enterprise value:

  1. profitability,
  2. competition,
  3. growth, and
  4. cost of capital.

Companies with high excess returns are likely to attract competition in the marketplace, leading to a shorter competitive advantage period in the company's valuation. Traditional Discounted Cash Flow approaches rely on terminal values and perpetuities. Unlike such traditional valuation approaches that utilize highly sensitive perpetuity assumptions, the Economic Margin approach incorporates the widely accepted economic principle that competition will compete away excess returns over time. The EM Framework explicitly models the effects of competition to gradually eliminate the excess spread a firm generates above or below its cost of capital (Economic Margin).


EM is grounded in the widely accepted economic theories of Noble winners Merton Miller and Franco Modigliani and can help identifying companies trading above or below their intrinsic valuations across sectors, market capitalization groups, and growth/value universes.
 

When doing a calculation of EM (formula) one has to bear in mind the numerator of the EM (like EVA), is based on economic profit, which helps focus managers on value creation. Unlike EVA, however, EM adds depreciation and amortization to cash flow and instead incorporates the return of capital explicitly in the capital charge. Also (like CFROI), Economic Margin is based on gross assets, which helps to avoid the growth “disincentive” typically associated with net asset based measures. Unlike CFROI, however, EM’s cash flows are unlevered (i.e. all equity financed) and do not mix operating and financing decisions.


Compare with Economic Margin:  Economic Value Added  |  Market Value Added  |  CFROI  |  CVA  |  EBIT  |  EBITDA  |  P/E Ratio  |  Cash Ratio  |  Current Ratio  |  Return on Equity  |  Fair Value  |  TSR  |  PRVit  |  DCF

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