CFROI as a Performance Metric:

Issues Solved By AFG’s Economic Margin

1
 Basic Project Facts

Capital 100 Cash Flow/Year 19

Life 10 Discount Rate 10%
Reinvestment %: 5%

1 2 3 4 5 6 7 8 9 10

Cash Flow 19 19 19 19 19 19 19 19 19 19
Discount Factor 1.10 1.21 1.33 1.46 1.61 1.77 1.95 2.14 2.36 2.59
Present Value 17.27 15.70 14.27 12.98 11.80 10.73 9.75 8.86 8.06 7.33

Sum PV 116.75
Investment 100.00
NPV 16.75

We will start with this basic project to examine how well CFROI links to reality. Notice
how the true performance of the project remains constant each and every year. It
generates $19 of cash flow, but can only reinvest those cash flows in future projects
that only generate 5%. A useful metric must reflect that the project’s performance is
not changing over time, and will not be distorted by the lower reinvestment
opportunities available to investors.
 CFROI Overview
Net Income
+ DDA Expense
+ Int. BFIT
Cash Flow: + Rent
+ R&D
± Other Non-
Depreciating
Assets:
Cash
+ Inventory
+ Other
Asset Life
Gross Investment:
Total Assets
+ Acc. Dep.
+ Infl. Adj. GP.
+ Cap. Rentals
+Cap. R&D
– Non-Debt Curr. Liabs.

The figure above lays out the basic structure of a CFROI calculation. The basic components are:
Gross Investment Asset Life
Annual Cash Flow Non-Depreciating Assets

Notice that this is essentially an IRR calculation, which fundamentally assumes that all cash flows
will be reinvested at the IRR. This is not a realistic assumption and significantly distorts the ability
of CFROI to accurately model a company’s true return. This is clearly illustrated on the next
page using the information from our initial example.
 CFROI Overview
Non-Depreciating
Assets: $0
Cash Flow: $19

Asset Life:
10 years
Cash Flow IRR: 13.77%
Gross True Cash IRR: 9.10%
Investment: $19 Error: 51%

In this example, it is easy to see that as a result of assuming all cash flows are reinvested at the
calculated IRR, rather than the rate at which they can actually be reinvested, a Cash Flow IRR
measure has significant amount of error. In this example, the true return to this project is
approximately 9.1%, not the 14% generated by the naive assumptions of an IRR model.
CFROI: Mixes Operating and Financing Decisions

Company Unlevered Levered Unlevered Levered

Sales 95 95 Gross Plant 100 100

Operating Expenses 70 70 Acc. Dep. 10 10
Depreciation 10 10 Net Plant 90 90
Operating Income 15 15
Total Assets 90 90
Interest Expense 0 5.6

PreTax Income 15 9.4 Debt 0 80

Equity 90 10
Income Tax (40%) 6 3.76

Net Income 9 5.64 Total Liab & Equity 90 90

Company Unlevered Levered

Net Income 9 5.64

DDA 10 10 Because CFROI does not separate the effects of
Interest Expense 0 5.6 financing from operations, it is easily distorted by
Cash Flow 19 21.24
firms that change their capital structure. By
Gross Investment 100 100 increasing its leverage in this example, the firm is
able to increase its calculated CFROI by over 20%.
Life 10 10
This is similar the distortions inherent to an ROE
CFROI 13.77% 16.71% measure, and another reason why CFROI can lead a
money manager to false conclusions about the
ROE 10.0% 56.4%
performance of a company.
AFG’s Economic Margin Addresses Equity
Analysis Basics

• Evaluating an investment requires answers to three questions:

– How much capital is required?

– What is the cash flow?

– What are the opportunity costs of capital?

• AFG’s Economic Margin Framework addresses each of these issues in a systematic manner

that corrects the distortions inherent to as reported accounting data

AFG’s Economic Margin Calculation:

Operating Cash Flow - Capital Charge

EM =
Invested Capital

AFG’s Economic Margin Framework is unlike any other performance

metric available to investment professionals. Unlike EVA, Economic
Margin is driven by operational cash flow that leads to an accurate
valuation approach. Also, unlike CFROI, Economic Margin is not
driven by simplistic and unrealistic IRR assumptions.
In essence, Economic Margin is a blend of the operating cash flow basis
of a CFROI, with the economic profit basis of EVA. The end result is a
metric that accurately realistically captures a firm’s true economic
performance and consistently and successfully links to market valuations.
Economic Margin Calculation Details

Operations Based Cash Flow: Capital Charge:

+ Net Income Return on and Return of Capital
+ Depreciation & amortization that captures company specific
+ After Tax Interest Expense economic circumstances.
+ Rental Expense Net Int. Adj.
+ R & D Expense
± Non-Recurring Items

Inflation Adjusted Invested Capital:

+ Total Assets
+ Accumulated Depreciation
+ Gross Plant Inflation Adjustment
+ Capitalized Operating Rentals
+ Capitalized R & D
- Non Debt Current Liabilities
 AFG’s Capital Charge – The True Capital
Charge

G iv e n 5 % W A C C , W h a t M u s t P r o je c t Y ie ld T o B r e a k E v e n ?

S a lv a g e :
AFG’s Capital Charge
i = 5
$5000
correctly adjusts for each
FV
company’s asset life and
mix characteristics to
L if e = 1 0 y e a r s provide the correct cost of
N wealth creation across
In v e s t m e n t : PMT = ? industries.
$ 1 0 ,0 0 0
PV

A n n u a l E c o n o m ic C h a r g e = $ 8 9 8 Notice there are no

reinvestment assumptions
such as those inherent to
N FV 0% 50% 100%
the CFROI calculation,
$ 1 ,7 2 8 $ 1 ,1 1 4 $500 that distort AFG’s
7
Economic Margin from
10 $ 1 ,2 9 5 $898 $500 reflecting a company’s
true performance.
13 $ 1 ,0 6 5 $728 $500
Economic Margin: Properly Separates
Operating and Financing Decisions
Company Unlevered Levered Unlevered Levered

Sales 95 95 Gross Plant 100 100

Operating Expenses 70 70 Acc. Dep. 10 10
Depreciation 10 10 Net Plant 90 90
Operating Income 15 15
Total Assets 90 90
Interest Expense 0 5.6

PreTax Income 15 9.4 Debt 0 80

Equity 90 10
Income Tax (40%) 6 3.76

Net Income 9 5.64 Total Liab & Equity 90 90

Company Unlevered Levered

Net Income 9 5.64 Unlike the CFROI calculation, AFG’s

DDA 10 10 Economic Margin properly separates the
After Tax Interest Expense 0 3.36
effects of financing and operating
Cash Flow 19 19
decisions. Notice that regardless of how
Gross Investment 100 100 the project is financed, AFG’s Economic
Margin properly focuses on and captures
Capital Charge 16.27 16.27 the operating returns of the firm and is
EM 2.73% 2.73% not distorted by how those operations
are financed.
 Economic Margin Framework

Linking Performance to Value

Market Value/ 5
R2 = Near 0 Invested Capital
100
Price/ 4
(“MVIC”)
Earnings 80 R2 = .61
3
60
2
Data: S&P 500
1

0 Data: S&P 500

-100 -50 0 50 100 150 200 250 300 -15 -10 -5 0 5 10 15 20 25

Earnings Growth Economic Margin %

Successful companies measure results, make decisions and set strategy with Economic Margin is a more complete performance measure for companies
the goal of creating value. A company’s performance measures must serve to use to guide performance and motivate employees. Executives consider
as a proxy for its market value creation. While important, S-T Earnings alone Cash Flow, Investment, Competition & Risk when setting strategy. The
are a poor indicator of a company’s value, due to what they do not measure. above charts show that investors do the same.
 Economic Margin Framework

AFG’s Equity Analysis Framework:

Evaluating Corporate Performance

1. Focus the analysis process on understanding current and

expected levels of economic performance:
Invest in improving EM companies.

2. When evaluating companies, ensure that their strategy lines

up with their economic performance:

Positive EM companies must invest

Negative EM companies must divest
 Economic Performance & Equity Selection

Changes in Economic Performance Leads to

Changes in Market Performance
Theory:
6
5
4
Changing EM Levels lead to changes
MV/IC
3 in market multiples.
2
1 The market rewarded and punished
0
-1 5 -1 0 -5 0 5 10 15 20 25 improvements/declines in economic
performance
Economic
Margin

Annual Return for Portfolios Formed on Forecast EM

Fact: 3%
Change versus Entire Universe (3/96 - 12/03)

2%
Companies with expected EM 1% 2.68%
improvement outperform those with 0%
expected declines by over 540 BP -1%
-2.75%
annually. -2%

-3%
Top 50% EM Change Bottom 50% EM Change

Source: AFGView client databases from 4/96 to 12/30/03

Universe size: 4,000 to 5,500 firms
 Economic Margin Framework

Economic Performance and Corporate Strategy

Economic
0
Margin

-
Wealth Destroying Break-Even Wealth Creating
Business Business Business

• Earn right to invest; • Focus on • Grow the

Strategy Divest losers; Profitability and Business, to
Identify core Efficiency; Growth capture positive
competencies is irrelevant NPV opportunities
 Economic Margin Framework

Economic Performance and Corporate Strategy

Annual Return Spreads vs. Universe of Firms Growing

6%
Assets at least 10% Annually (10/96 - 12/03) Theory:
4% Firms earning less than their cost of
2% 4.55% capital should focus on improving core
0%
businesses and divesting losers, while
-2%
-4% -7.45%
those with positive EM’s need to deliver
-6% growth to capture NPV positive
-8% opportunities.
-10%
Positive EM & Investing Negative EM & Investing

Annual Return Spreads vs. Universe of Firms Divesting

Assets at least 10% Annually (10/96 - 12/03)
Fact:
1% Firms expected to follow wealth creating
0.09% strategies outperform those that do not by
0% up to 1200 BP annually from 10/96
through 12/03. The market rewards
-1%
-2.03% economic wealth creation.

-2%
Negative EM & Divesting Positive EM & Divesting

Source: AFGView client databases from 10/96 to 12/03

Universe size: 4,000 to 5,500 firms