linking-performance-to-valueBy Saul Marquez

A great company is most often measured by its ability to create wealth for its shareholders.   With that in mind, The Applied Finance Group developed The Economic Margin (EM) Framework to measure corporate performance from an economic cash flow perspective, which enables investors to gain an objective “report card” of a firm’s economic profitability over time. While this is an effective way to identify great companies, you must link a firm’s corporate performance to its value in order to successfully identify attractive investment opportunities.

Economic Margin

Historical levels of Economic Margin help us understand how well the business has been run.  Looking at the Wealth Creation Report below of Apple, we can see that from 2004 Apple has delivered consistently positive and improving EM levels.  It’s not surprising that it was able to significantly outpace the S&P500 over this time span.

Apple Wealth Creation Report

aapl-wcrConversely, looking at the same Wealth Creation Report for Metabolix, the trend is the exact opposite over a similar timeframe. From 2004 to now, Metabolix, Inc. has delivered negative EMs every year, which have deteriorated further and further for the past decade. Companies with negative and declining EM levels tend to underperform, just as Metabolix, Inc. has considerably underperformed the S&P500 since 2004.

Metabolix, Inc. Wealth Creation Report


It is a fact that the market rewards companies with higher EMs. The chart below illustrates the distinct correlation between levels of Economic Margins and MV/IC. When examining a broader universe like the FTSE World Index, you can see that the market is willing to pay more for the invested capital base of firms that generate higher levels of Economic Margins.


Historical EM levels tell us how well the business has been run, such as with Apple and Metabolix, but what drives the intrinsic value of the company and really helps to identify investment opportunities are the company’s future levels of Economic Margins.

Intrinsic Value

When buying a company, you are essentially paying for its future expected performance.  Traditional models that use accounting ratios, as well as valuation models that incorporate perpetuity assumptions are flawed and misleading. Assuming that a company’s performance will stay constant forever, without facing the effects of competition is not an economic reality.

AFG’s Intrinsic Value approach leverages corporate performance data as a primary input into its proprietary discounted cash flow model.  A firm’s intrinsic value is not only a function of current levels of profitability and growth, but also where these EMs migrate over long-term time horizons. AFG’s competitive advantage period (CAP) incorporates competitive forces to ensure that long-term assumptions more accurately reflect the characteristics of a business’s life cycle.   AFG incorporates an assumption that Economic Margin (EM) levels will eventually fade to zero at a rate unique to each firm as we transition from historical or near-term EM forecasts to long-term expectations.

The CAP for a company can range anywhere between 7 to 39 years and is driven off of a four-factor regression model that focuses on EM level, EM volatility, EM trend and size of the firm.

EM Level – A company with very high historical EMs indicates that the company is highly profitable.  Highly profitable firms attract competition; thus, the model will decay the levels of EMs much faster than a company with lower EMs.

EM Volatility – A company with very volatile historical EM levels will have a shorter CAP than a company with more consistent historical levels of EMs.

EM Trend – If a company’s EMs are on an upward trend, the CAP will be extended; or conversely, if a company’s historical levels of EMs are on the way down, the CAP will be shortened.

Invested Capital (Size) – In terms of invested capital, the model assumes that it is more difficult to erode profits from a larger, more established company; thus, the CAP will be extended for larger companies, and the CAP will be shortened for smaller companies, based on each company’s total invested capital.

Competitive Advantage Period


When EM’s reach zero, the company is essentially earning its cost of capital, so growth becomes irrelevant. The net cash flows implied by the fading Economic Margins and diminishing capital growth over each firm’s Competitive Advantage Period can then be discounted to a present value estimate of a firm’s value. Debt and other obligations are subtracted to estimate the intrinsic value of a firm’s equity and then divided by current shares outstanding to estimate the firm’s stock price. By having an objective calculation of a company’s CAP, we are able to mitigate the effects of human biases which often blindside investors. By linking performance to value, we are able to identify which companies are trading at the deepest discounts to their intrinsic value.


Applying systematic rules to develop intrinsic value estimates over time, AFG can develop additional insights into the performance. The chart below reflects the annualized performance, ranked by global sectors, of the Bottom most overvalued quintile (F) vs the Top most undervalued Quintile (A).

Global Percent to Target Sector/Style Performance

iv-performance-breakdown-across-all-areas*AFG Global Database, Percent to Target (Global Sector Quintiles), 12/31/1991 – 12/31/2015

Note that performance is attractive across all sectors, size and style (growth/value). AFG’s intrinsic value score can be used to distinguish winner from losers from any universe of stocks over the long-term. The reason why great companies are not always great investments is because the price might reflect an unrealistic set of expectations.  Mispriced equities are generally companies which market has not priced the economic cashflows that are being discounted.

Screen of Actionable (TRUMP) Investment Ideas

In searching for potential beneficiaries of a Trump presidency, we examined the candidate’s statements of lowering the tax burden on corporations.   The companies which will benefit the most are those which are profitable.   The following is a list of stocks that have positive EM’s and are currently trading at a discount to their intrinsic value.  If Trump does lower corporate taxes, these stocks might gain an extra boost.  If you have access to AFG, you can do additional due diligence through our Value Expectations interface as discussed in this article.


About Saul Marquez
Partner at The Applied Finance Group

Focus areas:  Portfolio Consulting, Business Development
Joined AFG in 1998




Peter Simmons, JD
Peddock Capital Advisors – Assets Under Management – $250 Million
AFG Client Since 2008


1.Can you tell us a little about Peddock Capital Advisors, LLC (Who you serve, philosophy)?

Peddock Capital Advisors was established in 2008 to provide customized portfolio management services utilizing individual equities and fixed income securities to meet the goals and objectives of our clients.  We manage $250mm in client assets, with much of the equity research provided through AFG.

2. You have been a client of The Applied Finance Group (AFG) since you started your firm in 2008, what sets AFG apart from other equity research providers?

While we have used AFG since our founding, I recognized the merits of AFG’s equity research and underlying investment thesis at a prior firm.  Peddock Capital is a boutique firm with five employees, three of which are involved in the investment process to one degree or another.  What we believe sets AFG apart from other providers is the consistency of the research, the discipline to the underlying investment philosophy, the historical results, and the ability to utilize one or more of the AFG models in the construction of our clients’ portfolios.  The ongoing support we receive both technically and through the investment team is also a great value to us.

3. How has incorporating turnkey strategies like the AFG 50 helped your firm grow?

We use about 85% of the AFG 50 on an ongoing basis, the ability to use the AFG 50 as our core equity model allows us to build high quality portfolios using proven research, and leveraging that capability across a broader client base. Having the AFG 50 available to us allows more time to be dedicated to client facing activities which we believe allows us to grow our business more efficiently and profitably.

4. How does AFG’s research applications help save time and manage client portfolios?

The various optimization tools and excel add-ins allow portfolio managers to quickly leverage AFG’s investment philosophy.  For client inquiries about specific stocks the AFG modeling functionalities provide a robust but comprehensive means to identify relative value (or lack thereof).  In addition the Quarterly Focus List in conjunction with the screening and replacement idea tools while leveraging the AFG grading system are very efficient methods for idea generation.  A personal favorite of mine is the intrinsic value chart which is an excellent way to see how well AFG’s standard intrinsic valuation model has tracked a particular stock’s market price.

5. Any additional comments about AFG?

The merits and utility of AFG’s research process is well supported by historical evidence and obviously leveraging research solutions with such strong track records is important to us.  However, AFG also does a great job of supporting the investment process by providing regular education and training to enable users to more effectively leverage the Economic Margin framework and identify value.  In addition, AFG has done a good job with listening to users as it looks to better understand our needs and ultimately provide improved tools and functionalities to optimize the investment process.