Sharing success: How does a high-growth, privately held company compete with industry giants to attract and retain the best people?

How does a high growth challenger business attract and retain good quality people?  Can the way you pay your people be used to differentiate your business in the market for talent?

In this case study we look at how West Australian based Perth Energy is using entrepreneurial rewards to take on the giant of its industry and how that has led the company to think more broadly about how it measures success, thinks about investment opportunities and sets strategy.

Download the full case study here: Perth Energy case study

Sharing success

In the late 1990s Ky Cao was working for the West Australian government owned power monopoly Western Power, when reform of the industry presented a once in a generation opportunity.

Cao saw the future would be an openly contested electricity market with privately-owned retailers and generators competing for customers, improving service and delivering value.

He left the safety of his job at Western Power to found Perth Energy, relishing the chance to be at the forefront of change in his industry. He raised seed funding from a group of Perth investors and by 2006, the business had revenue of over $8m.

By 2010 Perth Energy had established itself as a leader amongst a small group of commercial providers that competed with the government owned retailer, now renamed Synergy. Cao had also won the support of one of the region’s leading infrastructure investment houses, New Zealand listed firm Infratil, which took a majority stake in the company to help fund the purchase and installation of a $130m, 120 megawatt power station at Kwinana, south of Perth.

As a mark of his achievement, in 2011 Cao was presented with the prestigious Ernst & Young Entrepreneur of the Year award for the Western Region.

Attracting and retaining key people

But as new participants followed Perth Energy’s lead into the industry and the West Australian mining boom continued unabated, the competition for staff presented Cao and the Perth Energy Board with a new problem: how to attract and retain quality people?

“Electricity and gas supply is a relatively complex industry,” Cao explains. “It requires technical and commercial brainpower and experience. To attract and retain good staff and align their interests with those of the company, we needed an incentive scheme that fairly, transparently and efficiently linked company performance to staff bonuses. And it needed to cover short term and long term aspects.”

Rod Jones, a director of Perth Energy and founder of the ASX listed global education business Navitas Limited, suggested Cao contact Juno Partners Managing Director, Justin Bown.

“Justin had helped Navitas put in place a profit sharing program that offered a meaningful reward for staff, but only if gains were sustained over three or more years”, says Cao. “It had also allowed greater variability in employment costs: up when the business could afford it, but well down and acting as a cushion to profits when the business had an inevitable down year.”

Juno Partners was engaged to develop and implement a profit sharing scheme with similar qualities for Perth Energy late in 2010.

“We spent about three months working through all the design considerations with Juno Partners. We discussed a range of options that would allow for rewards to be uncapped, but in a way that ensured only sustained gains were rewarded,” says Cao.

Measuring success

An important part of making the program shareholder-aligned was the choice of metric to measure performance. Juno’s Justin Bown explains, “Most people come to work each day wanting to do a good job, but every employee needs their manager to clearly define what ‘good’ looks like.”

“Justin asked us to think carefully about how we defined good performance”, continues Cao. “Given the capital investment program that lay ahead of us, we chose Economic Value Added (EVA) as the financial metric at the heart of our reward program.”

EVA was developed and popularised by US consulting firm Stern Stewart & Co. in the early 1990s. “It’s profit as it would be measured by an owner,” says Cao, “that is after including a charge for the shareholder’s money tied up in the business. Traditional accounting profit charges for the use of the bank’s money [interest], but not for the use of shareholder’s money. By charging for all the capital tied up in the business, EVA gets staff to think about revenue and expenses but also asset utilisation and working capital management. Other measures like EBITDA don’t do that.”

Cao had come across EVA earlier in his career and the logic of it appealed immediately. “It clearly shows the value a company creates for its shareholders. Our goal was to share the success we had with our staff in a way that aligned their interests with those of shareholders, so sharing sustained growth in EVA made really good sense.”

Owner-like rewards

The ‘ValueShare’ plan was approved by the Board in February 2011. In addition to the use of EVA, it includes other aspects designed to differentiate Perth Energy in the market for talent and align the interests of employees with those of shareholders.

The plan offers uncapped potential – both on the upside and the downside – but with the safeguard that rewards declared in any one year above a pre-set threshold are deferred and settled over time, provided the employee sticks around and gains are sustained.

The sharing formula is set for three years in advance, providing certainty to the Board and accountability to managers. “I’d seen the crippling impact that tying bonuses to budget could have on the planning process,” says Cao. “You’re basically paying people to lower their forecasts and game the system. We’ve got away from all that, again making the culture more entrepreneurial than our competitors.”

While the majority of rewards are based on the financial performance of the Group, Cao also wanted to recognise the contribution made by individuals. He retained a small pool to reward outstanding achievement by individuals, allocated annually by him as Managing Director.

“The EVA reward is the bigger number, it rightly focuses attention on how we perform as a team,” says Cao, “but the individual reward balances that and allows me to recognise those who have put in a particularly good effort during the year.”

To make the most of the change he had led, Cao recognised the importance of education. “Having designed and gained approval for the new program, we wanted staff to embrace it and understand what they needed to do to grow EVA.” Juno Partners led education sessions that were reinforced by changes to monthly reporting. Cao continues, “I was pleased to see how quickly people picked up on the principles and the way conversations began to give more emphasis to efficient capital management.”

Changes to capex and planning

Changes were also made to the capital expenditure and planning processes. “We began by including EVA in capex proposals and the annual and long term plans we presented to the Board.” Cao says. “And that gave great focus to balancing profit and capital growth. But after a few years we became more focused on the conditions that were necessary for EVA growth.”

“Only about 50% of Australian businesses are profitable from an EVA perspective,” Bown adds. “To grow EVA you have to be investing funds at attractive rates of return, which in turn creates wealth for owners. But because high returns are the path to creating wealth, any business that enjoys high returns usually finds they are quickly surrounded by competitors looking to mimic their offering, but at a lower cost, or with more features.”

“To grow EVA sustainably therefore, you have to think about how to create value for your customers, but you also have to think about how you’re going to defeat the ravages of competition and keep a worthwhile slice of that value for yourself.”

Cao comments, “We started out looking for a way to share our success with our people and we’ve achieved that, but that journey also brought other benefits. It forced us to define clearly what we expect of our people and the company and think through what it is that really drives value for shareholders. It’s been a very useful process.”

A key role in doubling revenue

Cao sums up, “Perth Energy has always been a forward-looking company, not least because we were instrumental to the opening up of the electricity market in WA in the 2000s. This reputation helped us attract high quality staff to the company, which at the time was still a small business.”

“Our retail business grew ten-fold in the five years to 2010 and at the same time our generation arm was in the midst of delivering on time and on budget the Kwinana Swift power station project and soon after a second, $90m, 82 megawatt power station in Merredin, east of Perth.”

“So we had to implement innovative management tools to glide the company’s operation into medium sized enterprise mode. The ValueShare scheme was an important part of that.”

“The results from the first 3-year cycle, which paid out in FY12, 13 and 14, show the scheme working well. We are now into the 2nd 3-year cycle and staff have become very familiar with and supportive of the rationale, intent and transparency of the scheme.”

“The introduction of the ValueShare scheme has played a key role in Perth Energy doubling in size to nearly $300m in turnover, without a hiccup on the HR side.”

Five elements to make managers think and act like owners #1: Reward sustained improvements in profitability

In this series of articles, we’ve looked at some of the most common mistakes that privately held companies make in approaching the question of incentives, and we’ve sketched out the common themes that owners tend to look for in an incentive plan.

Let’s now move to see how those themes can be realised in practice, by including five key elements in the incentive plan design that will make managers think and act like owners.

#1  Reward sustained, multi-year improvements in profitability
Ultimately an ‘ownership-like’ incentive plan must have financials at its heart, as it is sustained gains in financial performance that power the value of a business. Single period spikes in performance are unlikely to grow the value of the business a great deal however – buyers look for high levels of ‘repeatable earnings’. The more reliable the profit flow, the higher the premium buyers are likely to pay for a business.

I’ll discuss how to reward sustained gains in element #4, but it is worth focusing on how ‘profit’ is defined first, because, as we have seen, the most common profit measures, such as EBIT and EBITDA (or Net Profit, Earnings Per Share, Return on Equity and so forth) can actually encourage decisions that reduce, rather than grow, the value of the business.

One measure of profit that can be relied on to drive decisions that will grow the value of the business is ‘Economic Profit’. Economic Profit is the only metric that can be measured as easily as EBIT or Net Profit and yet ties reliably to wealth creation for owners. It’s measured like this:

Economic Profit calculation

Most owners know that ‘Profit’ is what is left over from sales revenue once all the costs of running the business have been taken out.  But accounting profit forgets one very important cost – the cost of using shareholder funds.  And by failing to put a price on the equity used to fund the business, accounting profit effectively says it’s free.

Pay managers to grow accounting profit and they will be encouraged to use as much of the shareholders’ money as they can put their hands on, after all its free and if they invest it at just 1%, accounting profits – and their bonuses – will grow.

But by charging for the owner’s capital used in the business at a rate that reflects what could be earned elsewhere at similar risk, managers are encouraged to treat capital like the scarce and valuable thing every business owner knows that it is.

Economic Profit puts into practice what anybody starting a new business has to think about from day one: if I put my savings into this business, will it generate more profit than I could have got elsewhere at similar risk?

For managers on an incentive plan linked to Economic Profit it forces them to think the same way: not just will this decision be profitable, but will it make enough profit to justify the owner’s investment?

In the next article we’ll discuss how to align the payoff profile of managers to that of owners.

Wealth = Quality x Quantity Part 4: Competition can be hazardous to wealth

‘The production of wealth,’ as 19th century philosopher John Stuart Mill observed, ‘has its necessary conditions’.

For senior executives and directors charged with growing the wealth of shareholders, few things could be more important to understand than the ‘necessary conditions’ for the production of wealth.

In this series of articles, we’ll share the findings of our research into wealth creation in Australian equity capital markets and layout a clear framework that describes the necessary conditions for the production of wealth.

In this article, we’ll look at impact competition has on returns on capital employed and Wealth Creation.

A quick recap
In the first article in this series, we looked at the findings of our research into why some companies create wealth, while others destroy it.

We showed that the creation of wealth is a function of ‘Quality’ and ‘Quantity’. ‘Quality’ is the rate of return that the company is able to generate on the capital entrusted to it, calculated by its sustained (say 5 year average) Economic Profit Spread ie its Return on Capital Employed (ROCE) less its Weighted Average Cost of Capital (WACC). ‘Quantity’ is the amount of capital that a company can put and is the great magnifier of Quality.

In the second article we argued that it is actually expectations of ‘Quality’ and ‘Quantity’ that are the key determinants of wealth creation, but that for most businesses, the history of the business is a good guide to the future and hence Quality and Quantity expectations.

In the third article we looked at the macro picture and showed that the top quartile of Wealth Creators combined both Quality and Quantity.  The second quartile had Quality without Quantity, the third quartile had low Quality and Quantity and the bottom quartile, those that destroyed wealth combined low quality with large quantities of capital.

Competition can be hazardous to wealth
Why are some businesses able to achieve and sustain high returns on the funds entrusted to them and create wealth while others languish with low returns?

High returns on capital are a rare achievement – just 26 of the 200 businesses we studied enjoyed average returns 10% or more above the cost of capital over the five years to 30 June 2013.

Like most of the businesses in our set, these businesses are professionally managed, offer compelling value propositions to their customers and play their part in the communities in which they operate.

The difference is the competition that they face.

For most businesses, the competition for sales, supplies or employees forces returns down to a level that just compensates investors for the risk that they take on. A short period of high returns attracts the attention of competitors and in the absence of a hard to replicate product or cost advantage, returns fall away as new players enter the market.

But a small group of businesses has been able to avoid these pressures and maintain high returns. Some, like Cochlear (#27) invest hundreds of millions in research and development and enjoy the protection of patents, allowing them to reduce competition over the life of the patent. Others, like BHP Billiton (#1) enjoy cost advantages over their competitors and pricing power in some of their businesses, while others like Reece Australia (#40) leverage brand recognition and distribution networks.

In each of these instances, the advantages have proven durable, giving investors confidence that high returns can be maintained well into the future, even in the face of competitive pressures. When these advantages can be maintained, wealth will be created, limited only by the size of the capital investment opportunity.

Key takeaway
The production of wealth has its necessary conditions. For many businesses this can be simplified into the concepts of ‘Quality’ and ‘Quantity’. Boards and senior managers can help their business create more wealth for shareholders by focusing attention on these two simple drivers and ensuring all strategic, as well as day-to-day decisions are made with this in mind.

More on how businesses can be engineered to create wealth can be found here.

Wealth = Quality x Quantity Part 3: The macro picture

‘The production of wealth,’ as 19th century philosopher John Stuart Mill observed, ‘has its necessary conditions’.

For senior executives and directors charged with growing the wealth of shareholders, few things could be more important to understand than the ‘necessary conditions’ for the production of wealth.

In this series of articles, we’ll share the findings of our research into wealth creation in Australian equity capital markets and layout a clear framework that describes the necessary conditions for the production of wealth.

In this article, we’ll look at the macro picture and how Economic Profitability links to Wealth Creation.

A quick recap
In the first article in this series, we looked at the findings of our research into why some companies create wealth, while others destroy it.

We showed that the creation of wealth is a function of ‘Quality’ and ‘Quantity’. ‘Quality’ is the rate of return that the company is able to generate on the capital entrusted to it, calculated by its sustained (say 5 year average) Economic Profit Spread ie its Return on Capital Employed (ROCE) less its Weighted Average Cost of Capital (WACC). ‘Quantity’ is the amount of capital that a company can put and is the great magnifier of Quality.

In the second article we argued that it is actually expectations of ‘Quality’ and ‘Quantity’ that are the key determinants of wealth creation, but that for most businesses, the history of the business is a good guide to the future and hence Quality and Quantity expectations.

The macro picture
Grouping the two hundred businesses in our research set into four quartiles further reinforces
the importance of quality and quantity to wealth creation.

Figure 1: Cumulative Wealth Created by Quartile

table

The total wealth created by the top 25% of businesses we analysed was $488 billion, more than 18 times as much as the next quadrant. These businesses fit the description given by Warren Buffett in his 1992 letter to fellow Berkshire Hathaway investors as the best businesses to own:

‘Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

That is, they invest large amounts of capital at high rates of return.

Indeed by 30 June 2013, the top quartile, including the likes of BHP Billiton, Commonwealth Bank, Telstra, CSL and Woolworths, had invested $678 billion – nearly three times as much as the other quadrants put together – at the highest average returns, 3.8% above what investors could expect to earn elsewhere at comparable risk.

The second quartile created a very credible $27 billion of wealth. Their average returns were close to those in the first quartile (2.6% above the cost of capital, versus 3.8% enjoyed by the first quadrant), but these businesses, including the likes of software developed IRESS Limited (#61) and retailer, Oroton Group (#96), were not able to put large amounts of capital to work at those rates (just $62 billion in total at 30 June 2013). With the accelerator of wealth creation missing, the second quadrant created a fraction of the wealth of the first.

The third quartile created $2.5 billion of wealth. This group has averaged returns over the past five years just above what investors could expect to earn elsewhere (their median Economic Profit Spread being 0.8%). Capital invested at 30 June is the lowest of the four quartiles at just $29 billion. With quality just above average and low quantity, this quadrant has done well to amass even $2.5 billion of wealth.

The bottom quartile has destroyed $55 billion of wealth by putting large amounts of capital to work ($158 billion by 30 June 2013) at low rates of return, averaging 3% below what investors could expect to earn elsewhere. Little wonder Buffett described these kind of businesses as the worst to own.

This quartile analysis shows the strong link between quality, quantity and wealth. The top 25% of wealth creators were also the businesses with the highest quality or EP spreads and the highest quantity of capital invested. The next 25% had good EP spreads, but less invested. The third quartile had breakeven EP spreads and the smallest amounts invested and the bottom 25% destroyed $55 billion of wealth by investing the second highest amount of capital at the lowest rates of return.

But where does accounting profit sit in all this? Given the emphasis placed on accounting profits by investment banks, the media and stock brokers, many managers would be forgiven for assuming measures like EPS, Net Profit and EBITDA are reliable indicators of wealth creation: more profit is always good for shareholders.

This is not borne out by our analysis. In fact accounting profit was shown to be a very misleading measure: while the top 25% of wealth creators also made more Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) than any other quartile, the bottom quartile, who destroyed $55 billion of wealth, came second in terms of cumulative EBITDA over the five years to 30 June 2013.

The problem is accounting profit measures like EPS, Net Profit and EBITDA say nothing about the quality of the business. They do not take into account the return investors could earn elsewhere on their funds and so businesses that employ large amounts of money at low rates of return can grow their accounting profits handsomely, all the while destroying wealth for investors.

For anyone interested in wealth creation, the evidence is compelling: wealth is not a function of accounting profitability. Wealth = Quality x Quantity.

The link to Economic Profit
There is a measure of financial performance that neatly captures both quality and quantity: Economic Profit, or as it sometime referred to, Economic Value Added.

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

Economic Profit formula

In the final article in this series we’ll explore why some companies earn higher returns on their capital than others and the hazardous impact that competition can have on wealth.

Wealth = Quality x Quantity Part 1: Our findings

‘The production of wealth,’ as 19th century philosopher John Stuart Mill observed, ‘has its necessary conditions’.

For senior executives and directors charged with growing the wealth of shareholders, few things could be more important to understand than the ‘necessary conditions’ for the production of wealth.

In this series of articles, we’ll share the findings of our research into wealth creation in Australian equity capital markets and layout a clear framework that describes the necessary conditions for the production of wealth.

In this article, we’ll look at the basis of our research and present the findings of our research which highlights the importance of quality and quantity.

The basis of our research
So what are the ‘necessary conditions’ for creating wealth? We set out to answer this
question by looking at a group of Australia’s largest listed companies and asking who has
created (or destroyed) wealth and then digging deeper to find the root causes [1].

We used a simple definition of wealth creation being the difference between how much has
been invested in a company and how much it is worth as at 30 June 2013. This measure has
the advantage of being a dollar measure of wealth, as opposed to a percentage measure,
like Total Shareholder Return or TSR and hence shows the true impact the business has had
on the economy.

The Wealth Created results are summarised in the tables following, ranking the two hundred
businesses in our set by Wealth Created as at 30 June 2013 and show, for example that BHP
Billiton (ranked #1 in the table) at 30 June 2013 had taken $137 billion of capital from
shareholders and lenders and turned it into a business worth $208 billion, creating a
staggering $71 billion of wealth [2].

Figure 1: The 2013 Juno Partners Wealth Creators Report

 

1-5051-100101-150151-200

By contrast, Newcrest Mining (#200) had taken $22.4 billion and turned it into $11.8 billion,
destroying $10.6 billion.

How do businesses create wealth?
How does a business like BHP Billiton create $71 billion of wealth? If you were to believe the prospectuses, annual reports and investor briefings issued by many of our listed companies, you would be left with the firm impression that what matters in creating wealth is EPS growth and EBITDA.

But our research shows that is not the case.

In fact, these metrics are unreliable at best and dangerously misleading at worst. Managers that navigate with these measures risk running their businesses off course and destroying wealth.

Our analysis shows that wealth creation is also not a function of sector. For example, some miners performed well, but some destroyed billions.

Wealth is also not just a matter of size. BHP Billiton is a very large company and created the most wealth, but Qantas (#196) is also a very large business, but its size did not save it from destroying billions.

Even growth per se does not matter. Both OZ Minerals (#198) and Westpac (#4) have grown their balance sheets in excess of 20% compound over the five years to 30 June 2013 but by the end of it, Westpac had turned $51 billion of investors’ funds into a business worth $90 billion, creating $39 billion, while OZ Minerals, turned $6.2 billion into just $1.3 billion, destroying $4.9 billion.

Instead, our research shows that the two most important conditions necessary for the creation of wealth can be characterized as ‘quality’ and ‘quantity’.

The importance of quality
Let’s look at the first condition: quality. The quality of a business is captured by the returns the business is expected to generate above what investors could expect to enjoy elsewhere at similar risk. We call this the company’s Economic Profit spread, or EP spread for short (for further detail on terminology, see our glossary of terms).

In assessing quality, we tend to give most emphasis to the EP spread the business has made over five years. This five year time frame helps iron out year-to-year fluctuations and gives a picture of sustained performance.

It shows, for example, the highest quality business in our set is Wotif.com Holdings Ltd (#57), which over the past five years has enjoyed an average return on capital employed of 56.5%, 45.5% above the rate investors could have expected to earn elsewhere at similar risk.

Intuitively, generating 45% more than the return required for risk is good performance, but when you consider a little under three quarters of the businesses covered in our research failed to generate more than 5% above what investors could expect for risk, then you begin to appreciate what are rare jewel Wotif.com is.

Quantity: the great accelerator of wealth creation
The second condition necessary for the creation of wealth is quantity, in this case the quantity of funds that can be invested at high rates of return. The more capital that can be put to work at high rates of return, the more wealth will be created.

This is best exemplified by BHP Billiton (#1) who not only enjoyed a median return on capital employed 10% above the return required for risk over the past five years, but also was able to employ an average of $83 billion a year at those rates, creating nearly $39 billion more profits than investors would require for the risk associated with their investment.

Quantity is the great accelerator of wealth creation. As good as Wotif.com’s returns are, the service nature of its business means that it does not organically generate large capital investment opportunities. It is hard to see how Wotif.com could ever employ $83 billion of capital in their business. Ultimately this restricts the wealth the business is able to generate.

But quantity without quality is a recipe for wealth destruction
But while the ability to put capital to work is important, we found quality must always come first. Investing large amounts of capital in low return, low quality businesses is a recipe for wealth destruction.

Newcrest Mining Limited (#200) is a good example of this. Over the past five years Newcrest suffered returns on average 2.3% below what investors required for risk. At the same time, it expanded its capital base, investing billions at low rates of return. The result was a valuation $10.6 billion less than what investors had poured into the business as at 30 June 2013.

Warren Buffett put it this way in his 1992 letter to fellow Berkshire Hathaway investors:

‘Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.’

In the next article we’ll discuss our findings regarding the importance of expectations.

______________________________________

[1] For the purposes of this study, our database comprised the 200 largest Australian domiciled public companies as at 30 June 2013, excluding investment businesses, such as listed investment companies, insurance and real estate businesses, those with less than five years of publicly available financial reports and those who made losses in three or more of the past five years.

[2] Note that in the table of data we list the 2013 average Capital Employed balance, being the average of the year-end results for 2012 and 2013. The 2013 year-end values cited in the main text of this article and used to calculate Wealth Created, will usually be a little larger.

 

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.