Economic Profit Growth

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.

Key Takeaways for the Department of Labor Fiduciary Rule

We anticipate that the U.S. Department of Labor's fiduciary rule will have significant consequences throughout the financial sector. Despite discussions with advisors, analysts, and financial institutions, there remain numerous questions about the rule's implications and the steps companies can take to prepare for emerging opportunities or minimize potential negative impacts.

As a result, we believe that wealth management firms must increasingly demonstrate why their recommendations are in the best interest of clients and that financial product makers must ensure that their offerings align with the new fiduciary reality. To address these issues, we have compiled a list of common questions and provided clear answers in our signature user-friendly Interlaken Advisors style.

For a more comprehensive analysis of the financial and strategic implications of the Department of Labor's fiduciary rule on financial industries and companies, we encourage you to request our reports: "The U.S. Department of Labor's Fiduciary Rule for Advisors Could Reshape the Financial Sector" and "Final Department of Labor Fiduciary Rule's Effects Are Substantial." Our reports delve into quantifying the assets affected, revenue impact, potential compression in operating margins, lessons to be learned from other countries that have passed similar rules, accelerating sector trends, and companies that are positively or negatively exposed to the rule.

Key takeaways from our analysis include the expectation that wealth management firms will need to determine, demonstrate, and document why their recommendations are in clients' best interests. To mitigate fiduciary risks, firms are revamping their financial product offerings and may use more third-party investment-management services. While the Department of Labor's jurisdiction primarily covers tax-qualified accounts, we believe that the rule will have secondary effects on taxable accounts and that fiduciary-like obligations will eventually extend to all advised accounts.

Although high-fee, complex products may still have a place in client portfolios, the justification bar is now higher and may require a more comprehensive view. The Department of Labor's fiduciary rule also affects Registered Investment Advisors and their representatives, particularly with regards to substantiating IRA rollovers.

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.