Beyond Earnings

6HOLT ECONOMIC PROFIT

“Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.”

—Warren Buffett, 1983

KEY LEARNING POINTS

• Unlike debt, which has an interest charge associated with it, there is no charge recorded on an income statement for shareholders’ equity. Accounting earnings are not economic earnings.
• Economic profit represents the economic earnings of a firm. It equals the spread between return on capital and the cost of capital multiplied by the invested capital. Companies able to beat their cost of capital are value creators while those that fall short are value destroyers.
• The value of an asset equals the invested capital plus the present value of future economic profits. For a given forecast, the EP valuation and FCFF will be equal.
• HOLT economic profit improves upon the conventional EP since it accounts for asset life, asset mix, and inflation. We show how to calculate HOLT EP and use it to perform a valuation.
• EP can be split into operating and acquisition components. Total EP should preferably be greater than zero, but it is more important that the change in EP is positive.
• Change in EP can be split into margin, growth, goodwill, and market risk components. You can identify how EP is evolving, and study trade‐offs such as growth versus margin compression.
• Amazon and Danaher ...