19th March 2019
We discovered a few years ago that there are three certainties in
life rather than the traditionally accepted two. They are death, taxes
and a pathological dismissal (or fear) of the economic profit (value
creation) concept. And yet we are able to quote success stories with the
application of this ‘financial witchcraft’ in such organisations as
Coca-Cola, Cadbury Schweppes, Gillette, Lloyds Bank amongst others.
What do we mean by value creation?
The guiding principle of value creation is a remarkably
straightforward construct: companies that generate a return on capital
which exceeds the cost of that capital, create value.
Given this principle, developed by the great economist Alfred
Marshall (Principles of Economics – New York, Macmillan, 1890) and
building upon the work of Adam Smith, it remains as relevant today as it
did when it was first published nearly 130 years ago. Furthermore, when
CEOs, Boards, Investors, advisors and indeed Governments tend to forget
about it, the results have often been nothing short of calamitous for
shareholders, employees and other stakeholders – the 2008 Banking Crash,
the rise of conglomerates in the late 1960s and 70s and the “internet
bubble” are good examples.
The problem with “accounting” earnings
In today’s world, many managers are taught to use accounting
earnings or some variant thereof eg EBIT (Earnings before Interest and
Tax), in order to measure business performance. Marshall’s great and
simple tenet tends to get lost in this subset of benchmarking where the
parts are more important than the whole. Why? Because earnings metrics
suffer from the following deficiencies:
- Earnings / earnings per share is an “incomplete” measure of
performance – it does not include any element for the amount and cost of
all of the capital needed to run and grow the business
- It is not a measure of cash flow. Earnings last year or next year
tells us very little indeed about the cash flows that the business will
deliver or needs to deliver in the future
- It contains nothing about how risky earnings are, either now or in the future
- It says nothing about the need for or role of intangible assets which are an increasingly important ingredient in many companies
- It is easily manipulated or distorted using perfectly legal accounting conventions
- It gives a poor signal between good growth, which advances the wealth of the organisation and bad growth,
which despite producing a positive outcome is nevertheless lower than
the (“unaccounted”) cost of equity capital and hence destroys value.
Marshall and execution
Thus “accounting” earnings metrics do not comply with Alfred
Marshall’s definition of value creation and hence decisions made using
such metrics are in grave danger of giving managers the wrong signal
when considering strategic alternatives and trade-offs. All too often,
once their strategies fail to produce the returns anticipated, Boards
and Management teams quickly turn to the cult of execution – “our strategy is right it is just that we need greater focus on execution” is a frequently heard mantra.
Recognising the importance of strategy delivery and the need for
executives with the “skill and will” for strategic execution, we remain
firmly of the view that an incorrect assessment of the organisation’s
competitive / economic position is the most likely cause of the
subsequent strategy failing to deliver.
Essentially the basic issue or problem with using accounting data for
complex strategic decision-making is that the information is incomplete
(see above) and is commonly not in sufficient detail in the right areas
from which to build out value-creating strategies. Consequently it
tends to lead managers towards the belief that “ALL GROWTH IS GOOD” which, if applied to the wrong area of the business, might actually accelerate value destruction.
An economic return
In considering this backdrop and also realising the need for a firmer
grip on value creation and destruction, many organisations have adopted
a value-based perspective for their strategy deliberations – central to
which is the use of economic profit defined as net
operating profit after tax less a charge for all of the capital used by
the business. Many companies have produced staggering returns for
shareholders including Coca-Cola under Roberto Goizueta and Lloyds Bank
under Brian Pitman.
“When you start charging people for their cost of capital, all sorts of good things happen.”
Roberto Goizueta – CEO of Coca-Cola between 1980 and 1997
Unlike any other business metric, economic profit combines three
things; the profit and loss account (NOPAT), the balance sheet (to
calculate Invested Capital and from that the capital charge) and an
external capital market measure, all in one number. It differs from
accounting profit because it includes an expense for the required return
of shareholder’s capital and consequently has a superior strategy
signalling attribute – see below the example from Enron…
Numerous factors were behind Enron’s eventual collapse, although
having a governing objective (earnings per share) so misaligned with
value creation was undoubtedly a major factor.
The left-hand diagram highlighted above includes all of the costs of doing business – the right-hand diagram does not. The evidence and differences between them is easy to see.
Perhaps Enron’s board of directors would have adopted a different set
of strategic decisions if it had seen the left-hand diagram rather than
the right-hand version which in turn might lead one to believe that all
growth is good which is not the case.
From a comparative standpoint, the attributes of the various measures are listed below;
It is clear to see that the economic profit concept is founded on
sound and quite grounded principles. It also draws upon the work of two
Nobel prize-winning economists – Mondigliani and Miller – and their
extensive deliberations cocerning corporate capital structures. So, to
have the economic profit concept dismissed as ‘nonsense’ on Twitter by a
football finance academic and ‘expert’ did raise our eyebrows by a few
Indeed, our expert went on to state that we appear to have something
of an obsession with the economic profit measure. We’ll take that as a
We are firmly of the view that British business would be
significantly more competitive in world markets if other captains of
industry, not to mention advisors, consultants and educators took a
similar perspective to that of our own. There is only one business
school in the UK at the University of Strathclyde (led by Professor John
Barbour) that has a value-based strategy course firmly established
within its syllabus (and which is frequently over-subscribed). From a
‘UK PLC’ perspective this cannot be the value-maximising way forward.
Indeed, it is not uncommon for CEO and Finance Directors to fall into
an initial state of denial and disbelief followed by apoplexy when
first confronted by their own economic profit numbers – particularly
when divisional and geographic perspectives are included. Eventually the
good ones come around to our way of thinking and want to understand
more as they increasingly appreciate the power of the insights from
taking an economic perspective and the potential future impact to their
So when it comes to looking into industry-level dynamics we usually
find that our observations and insights turn out to be both prescient
For example, the demise of Carillion and the exceptionally
challenging position of Interserve might have been identified by
management some 5-7 years prior if the economic profit measure signal
had been both appreciated and used as a basis for strategy development.
Indeed our own indexing capabilities clearly show a decline in the
ability to convert revenue into economic profits with an ongoing
downward signal for both companies between 2012-15 and beyond. The
“incomplete” earnings-based measures such as Operating Profit, EBIT etc
incline us to the view that everything was fine. As time has gone on to
prove, this was a grossly incorrect perspective.
Group Operating Profit measures between 2013 -15 remained relatively
stable as the economic profit measures clearly highlight the decline in
Both companies are not isolated cases. We frequently see the economic
profit trend highlighting difficulties in corporate health well before
the earnings-based measures pick it up, which is usually too late to
prevent a serious reversal in performance or share price, as was the
case with Tesco.
The above diagram shows Tesco’s economic performance in decine from
2009. Interestingly, the share price trajectory and the economic
performance of the company are not exactly strange bedfellows. The
prevailing media narrative in 2014 held that Tesco’s position was
directly threatened by the UK expansion of both Aldi and Lidl. Our own
work strongly suggests that Tesco’s non-UK and non-supermarket
activities were acting as a significant break on the company’s economic
output and that the decline in performance started at least 5 years
prior to the emergence in earnest of the German retailing giants within
The price of energy
Have you ever wondered why your energy bills are increasing at a
faster rate than the cost throughput from the wholesale energy markets?
It is due to the massive erosion in value as a result of an insatiable
demand for capital as the energy companies try to decommission and
replace ageing power plants.
The 2015-16 combined economic losses run to over £72m per day –
that’s approx. £26bn per year – for the Big 6 energy companies. Indeed,
our efforts in highlighting just how bad the situation was resulted in
the presentation of our economic profit data to a Parliamentary select
committee by Dr Philip Lee MP in 2013 and used to directly question the
economic performance of the Big 6 energy companies.
We forewarned the industry that things were going to get a lot worse
unless it and the Government took remedial action. Once again, as we all
cope with our increasingly costly energy bills a few years down the
line, we have sadly been proven to be correct with shareholders of the
“Big Six” having suffered appalling returns (since 2013) on their
A video of the select committee session can be found here.
Therefore, at this point we can confidently conclude that economic profit is hardly the stuff of ‘nonsense’.
And so we come to football. The beautiful game that does not create value and yet people wonder why?
By way of background, we first examined the world of football in late
2016 simply because as fans of the game we wanted to see exactly what
was going on from an economic profit perspective. Yes, there are a
number of experts that will report the balance sheet performance on a
club-by-club basis, discuss the effects of increasing/decreasing
amortisation and highlight the cash-generative capabilities of certain
clubs using EBITDA and other measures.
However, in a general sense that is as far as it goes. In our
consultative work we take a much more investigative role in proceedings.
We look for outliers and imbalances in financial operations and we seek
trends and signals using indices that enable a fair benchmarking of
performance. From our observations we are able to develop insight and
commentary using the most transparent and demanding of financial
measures i.e. economic profit.
As with the Enron example outlined above (although not as
catastrophic – just yet), we have found a number of underlying trends
conveniently masked by pre-tax and other earnings-based measures. We
have got closer to the true cost and investment by some very rich
individuals (and countries…) into their respective football clubs and we
believe we have established a direct relationship between “economic
profit efficiency” and relegation from the Premier League. We have
demonstrated the increasing usage and cost of capital in promotion out
of the Championship and we have clearly demonstrated the failings of
Financial Fair Play schemes.
Short of ideas?
The European Super League is often quoted as a concept based on greed. However the reality that we observe is that it is one of necessity
given the losses of the Premier League Top 5 (Spurs are generally
economically neutral). This has escaped many a commentator, pundit and
So our investigative process usually brings us towards developing ideas and solutions. Our previous blog (Financial Fair Play – Guilty as Charged?)
looked at the failings of such schemes and offered up a number of ideas
in terms of an alternative ruleset to ensure the future financial
security of football.
We do keep a reasonably close eye on media content within our areas
of interest. We do not see that many articles suggesting a new way
forward or offering an alternative pathway to prosperity for the
footballing community. Of course, we do miss a lot of the academic
output, but on the other hand, papers of note tend to get good coverage
in the wider media. But perhaps that’s our point. It is as if the status quo, as bad as it is, is almost universally accepted.
Seemingly, one of the more contentious ideas put forward by
us is the notion that clubs should be economically profitable. ‘Not so’,
says the expert. ‘Clubs exist not to make money…’ Ah, this is not the
first time that we’ve been subjected to this particular viewpoint.
What, then, is an acceptable loss and how is that loss going to be
defined? On this our “critics” offer no credible perspective or way
We are sure that the supporters of Aston Villa, Blackburn Rovers,
Bolton Wanderers, Charlton Athletic, Oldham, Notts County, Sunderland
and many other clubs that have been on the wrong end of the balance
sheet will have an opinion. Sadly losses in football, however you may
want to define them, are all too common.
It is unavoidably evident that the EFL Championship is a financial
basket case but are we the only entity to track the financial carnage of
promotion into the Premier League and the effects of a relatively quick
relegation (one-third of promoted clubs are relegated after one season,
two-thirds after three) on the balance sheet and subsequent club
performance? Perhaps we are, but we don’t see anyone else offering ideas
or potential solutions to this clearly unsustainable situation.
Indeed, given that clubs are run as limited companies, they are
subject to the same legal requirements and financial obligations as any
other type of business and as such they are compelled to be run in the
same way. So, as it stands there is no special treatment to be found
here, yet we advocate for new and specific legislation to be applied to
football clubs along with the appointment of an independent Football
Regulator who ought to be sufficiently empowered to ensure widespread
profitability throughout the game.
Such an arrangement would not create barriers, as the expert infers,
but would ensure that clubs survive as they are put on a path towards a
firmer financial footing along with the additional aim of eradicating
poor and often questionable owner behaviour via regulatory limits.
Frequently, we have written that there is a storm coming in the shape
of an alternative pan-regional club competition. It may be a European
Super League, a club world cup format or even a revamped Champions
League. The big clubs will do well out of it, whatever the outcome. They
will do even better if owners can eventually agree on a range of cost
control measures and limits as exemplified by that other big $$ sport,
American Football. As we have often said, it will be the American
influence both at club level and within the media that will dictate the
future direction of football – not the local entrepreneur made good –
given that a small but influential number have a foot in both sporting
What will be left behind once the European circus has elevated itself
away from the national leagues is of more concern. Without lucrative TV
deals and robust revenue streams, the lower reaches of the game will
suffer until balance sheets (and their respective benefactors) can take
no more. This is why simply doing nothing and merely observing is in
We have seen too many examples in other industries where leaders and
stakeholders have chosen to ignore the true position of their respective
businesses with alarming and definite consequences. We see the same
trends and the same thread of denial within football. Something needs to
happen. The debate needs to start now before it is too late.
Finally, there is Roberto Goizueta, undoubtedly a candidate for the
greatest leader of an American company (Coca-Cola), who said;
“Creating economic profit is the single most important driver of
the stock price (and hence valuation) of the Coca-Cola company.”
Now that is a worthy obsession.