Is your business engineered to create wealth? Part 2: Performance measures

Most CEOs would prefer to create more wealth for shareholders than less.

But most companies are not ‘engineered’ to create wealth – internal processes often act to hinder wealth creation, rather than encourage it.

In this article we look at one of the most pervasive barriers to wealth creation: performance measures.

As we’ve seen in part 1 of this series, wealth is created when funds are invested at high rates of return and destroyed when funds are invested at low rates of return. But incredibly, the most popular financial performance measures in use today such as Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) and Earnings Per Share (EPS) are silent on the rate of return, or quality of the business. And what’s worse, they actually encourage managers to destroy wealth by investing the money entrusted to them at low rates of return.

Consider a manager faced with an opportunity to add a new customer. If the business
goes ahead with the terms proposed by the customer, the impact on the Group’s financials
will be as follows.

Figure 1: Growing profits, destroying wealth

Growing profits destroying wealth

 

Any of the most popular performance measures, such as sales, margins, EBITDA and even ROCE improve if the manager takes this deal. But in doing so, they encourage him to invest the capital entrusted to the business at 8.2%, less than the 10% that investors could get elsewhere at equivalent risk – that is, these measures will encourage the manager to destroy wealth.

Indeed a manager can grow EBITDA or EPS, two of the most popular measures of performance in use today, by investing funds for a return as little as 1%.

As a consequence, all the creativity and hard work of a management team can unwittingly lead to wealth destruction if the compass that they use to guide decisions is a simple but misleading one, such as EBITDA.

Using EBITDA or any other measure that fails to capture quality and quantity of the business keeps the truth of the performance of the business back from managers and acts as an enormous barrier to the creation of wealth.

CEOs can remove this barrier by replacing EBITDA or similar measures with sustained gains in Economic Profit. Economic Profit is the only measure that captures both the quality of the business and the quantity of funds invested in it.

Figure 2: Economic Profit captures the key drivers of wealth creation

Economic Profit formula

 

Because EP goes down when funds are invested at low rates of return and up when they are invested at high rates of return, it guides managers, through all their efforts during a year, to create wealth, rather than destroy it. And it can be measured right down through the business, sharing responsibility for wealth creation throughout the management ranks.

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