Interlaken Advisors was a pioneer in promoting the importance of measuring Economic Profit (EP) as a means to manage and drive growth in the very best organizations that consistently outperform their competitors. In this commentary, we revisit this concept and highlight its value as a strategic framework for managing enterprise value.
To be successful, company strategies must ultimately focus on delivering outstanding financial performance over time. However, our experience suggests that many business strategies today lack an explicit economic foundation. While well-run companies prioritize customer satisfaction and strive to serve their customers in the best possible way, not all approaches to achieving these objectives necessarily drive superior shareholder value creation over time. Truly great strategies manage to deliver both superior customer and company value over time.
Delivering strong Economic Profit over time is equivalent to increasing company value and plays a critical role in developing and understanding winning strategies. By emphasizing the importance of EP as a metric, Interlaken Advisors encourages companies to focus on managing and measuring their value creation. Through this approach, companies can develop strategies that prioritize both customer and company value, leading to superior financial performance over the long term.
As a metric, Economic Profit has important advantages over most other metrics commonly used to set managers’ objectives. Economic Profit is unique in its combination of 1) an income statement measure, 2) a related balance sheet measure, and 3) an external capital markets measure. As such, EP has a signaling function that is superior to any other financial metric. In a single period, it provides line of sight into how much value a strategy is creating, while over multiple periods it provides an accurate view of overall value creation of such strategy. It also facilitates an objective evaluation of strategic alternatives as part of a multi-year valuation.
In addition, using Economic Profit is simple and it can be applied at all levels of the organization (e.g., at the BU, PMC, customer or brand level), allowing you to assess how different parts of your portfolio are contributing to value creation. It is absolutely the best proxy we have in our possession that links product-market performance and financial or capital market performance.
Finally, one major advantage of EP in our experience is that it makes it possible to consistently join-up strategic, capital allocation and operating decisions.
Nothing herein is intended to be investment advice. Investment in the stock market involves risk of loss. Past performance is no guarantee of future returns.