Economic Profit and Shareholder Value

Back in 1990, the concept of shareholder value creation was not high on the agenda of most bankers; indeed, even as the author penned these lines originally in the summer of 1995, the concept was still alien to many. The intervening years, however, have seen a significant increase in interest in the concept, and now hardly an annual report is complete without at least lip service to the idea.

This chapter focusses specifically on the concepts of economic profit and its cousin, free cash flow, as performance measures, and their role in supporting a shareholder-value-oriented approach to management. An underlying theme of much of this book has been the concept that efficient capital management is a key component of delivering value to shareholders. Why? Because the way in which shareholders assess the performance of management is to compare the returns earned on their investment with the minimum level of return required to compensate them for the riskiness of the investment. The capital invested is the single key driver, and it is the returns earned on this investment that we are interested in optimising.

As noted in Chapter 15 (see pages 253–254), the concept that is increasingly used to measure the efficiency of this process is often called economic profit (EP). This concept—sometimes referred to as “economic value added” or EVA1—is in fact no more than the application of standard discounted cash flow techniques to whole businesses. (The ...

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