Benchmark for true value

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: In the last few years, corporates have started adopting new performance measurement metrics with an emphasis on enhancing shareholder value, while sidelining the traditional accounting-based measures such as earnings per share (EPS) and return on equity (ROE). Among the various metrics being considered, the measure of economic profit (EP), also known as residual income, has turned out to be the most popular.

EP or residual income is based on the principal that an investment is required to generate a return commensurate with the underlying business risk. An investor would want to see the company meet or exceed this benchmark, or else the company has been unable to generate value. As long as the company generates returns in excess of the returns required by the financial markets for the risks involved, value will be created.

Makarand Bhopatkar, Faculty member-ICFAI Business School explains, "Markets have always recognised the fact that companies have to earn more than the cost of funds used." Research also indicates that there is a positive correlation between share price and changes in economic profits.

Although recently made popular, this concept has been around and in use for a fairly long period of time. The longstanding interest in residual income is no accident. It is a fundamental and compelling concept recognising that to create wealth, a company must earn more on its capital than its capital costs. The term ‘residual income’ was coined by General Electric in the 1950s. It was applied as early as the 1920s by General Motors and in the 1930s by Matsushita and was also termed as ‘excess earnings,’ ‘super-profits’ and ‘excess realisable profit.’

The concept of residual income or EP distinguishes the company from its shareholders. Under this view, equity capital is not free to the firm. Along with the cost of debt, the cost of equity capital also needs to be considered. Equity capital is considered more costly than debt capital due to the additional default and systematic risks that equity investors bear. Proponents of this view point out that omitting a charge for the equity capital could result in sub-optimal management behaviour. By adopting this approach, the management is made to think like the owners as against linking the performance to accounting earnings.