Beyond Earnings

2THE FLYING TRAPEZE OF PERFORMANCE METRICS

“As managements and board members improve their knowledge of the link between firms’ economic performance and share price, they will increasingly look beyond accounting earnings. They will gain conviction that large investments in core competencies and long‐lived, viable projects in which the firm has demonstrated skill can raise the company’s stock price, even if near‐term accounting results suffer from it.”

—Bartley J. Madden¹

KEY LEARNING POINTS

• Return on equity (ROE), a commonly used measure of profitability, is subject to numerous distortions and, therefore, unreliable.
• Return on invested capital (ROIC) is a better measure of a firm’s profitability. It is not influenced by capital structure.
• The P/E ratio can be related to a DCF model but is highly restrictive and subject to numerous distortions. Relative valuation metrics such as P/E and P/B should only be used as sanity checks.
• All things being equal, an increase in profitability results in an increase in value. All asset growth is not equal. Companies should only expand if they can generate returns on capital that exceed the cost of capital.
• The hallmarks of a sound economic performance and valuation framework are outlined.

MEASURES OF CORPORATE PERFORMANCE

Profit is a measure of gain from investment. Profitability is a measure of relative gain, typically scaled by the investment. A popular metric for assessing profitability is to compare reported or expected net income ...