Accounting is Broken - Investment Analysts Journal

Stern Stewart & Co.
Equity Capital is Costly
Economic profit eliminates
this glaring distortion.
It more accurately
m e a s u res corporate perf
o rmance by subtracting
the cost of all re s o u rc e s
used to generate re v-
enues, including the cost
of equity capital.
It doesn’t work out for
each stock, of course,
nor in every year, but
over time a portfolio of
common stocks does
tend to pro v i d e
investors with a 2 to 7
p e rcent re t u rn pre m i u m
that compensates them
for risk.
Although abstract in
n a t u re, the cost of equity
is as real as any cost
can be in terms of its
implications for a firm
and its shareholders. If
a firm cannot earn a
re t u rn on equity above
its cost, its share h o l d e r s
will abandon their supp
o rt for the stock and
will set its price at a discount
to book value.
Many of the past
decades’ high flyers like
WorldCom and Enro n
would surely have been
m o re deliberate in their
g rowth had they been
f o rced to recognize the
cost of all the equity
capital they were pouring
into their businesses.
As has been noted, the most egregious error accountants are now making is considering
equity capital a free re s o u rce. Although they subtract the interest expense associated with
debt financing, they do not place any value on the funds that shareholders have put or left
in a business. This astonishing oversight means that companies often re p o rt accounting
p rofits when they are in fact destroying shareholder value.
Economic profit eliminates this glaring distortion. It more accurately measures corporate
p e rf o rmance by subtracting the cost of all re s o u rces used to generate revenues, including
the cost of equity capital. At its most basic:
Economic Profit = Accounting Profit - The Cost of Equity
Unlike interest or wages, the cost of equity is not a cash cost. It is an opportunity cost. It
is the re t u rn that a firm ’s shareholders could expect to earn by purchasing a portfolio of
stocks in other companies of comparable risk. If a firm cannot give its shareholders at least
the re t u rn that they could earn by investing on their own, it will lose value. It does not
begin to earn a profit until it can cover the opportunity cost of its equity capital. This
insight is the fundamental diff e rence between accounting profit and economic pro f i t .
The re t u rn that investors expect from investing in equity portfolios has been the subject of
intense theoretical and empirical re s e a rch by academic scholars. The finding that has stood
the test of time is that investors want to be compensated for bearing risk, and over time,
they are. Shareholders so discount a firm ’s future prospects when they establish the price
they will pay for its shares that they are likely to earn a re t u rn well above the yield available
to them from relatively risk free government bonds. It doesn’t work out for each stock, of
course, nor in every year, but over time a portfolio of common stocks does tend to pro v i d e
investors with a 2 to 7 percent re t u rn premium that compensates them for risk. With gove
rnment bonds currently yielding about 5 percent, shareholders are now demanding long
run re t u rns from their equity investments of from 7 to 12 percent per annum. Companies
must earn that re t u rn as a cost of doing business.
Although abstract in nature, the cost of equity is as real as any cost can be in terms of its
implications for a firm and its shareholders. If a firm cannot earn a re t u rn on equity above
its cost, its shareholders will abandon their support for the stock and will set its price at a
discount to book value. But if a re t u rn above the cost of equity can be achieved, a firm will
sell for a premium over its book value, and it will have created wealth for its share h o l d e r s .
The cost of equity is the cutoff rate to create value with capital, an invisible but pro f o u n d
dividing line between superior and inferior corporate perf o rm a n c e .
The diff e rence between accounting profit and economic profit is often considerable. A
company with re p o rted net income of $80 million is on its face healthy. But if it ties up $1
billion in shareholder capital on its balance sheet, and if its cost of equity is 10%, the firm
is actually producing a $20 million loss compared to the alternative investment uses of that
capital. The likely consequence is that it will trade for a market value significantly less than
its $1 billion book capital, the diff e rence reflecting the shareholder wealth that has been lost
t h rough misallocation or mismanagement of capital.
Economic Profit = Accounting Profit - The Cost of Equity
Economic Profit = Accounting Profit - (COE% x $Equity Capital)
$ - 20 Million = $ 80 Million - ( 10% x $1 Billion )
Many of the past decades’ high flyers like WorldCom and Enron would surely have been
m o re deliberate in their growth had they been forced to recognize the cost of all the equity
capital they were pouring into their businesses.
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