MEASURING THE ECONOMIC PERFORMANCE AND VALUE OF COMPANIES

Abstract

Accounting performance measures such as earnings per share growth and return on equity and their related valuation measures (price to earnings and price to book ratios) have severe limitations in comparing the economic performance of companies and explaining how the market prices stocks. Although the traditional cash flow-based valuation methodologies as taught in business schools are, in theory, more sound approaches, they suffer problems in practical implementation. In particular, the large number of forecasts and arbitrary decisions that need to be made in deciding upon an appropriate discount rate prevent meaningful back testing of the approach. Hence the validity of the assumptions being made are always open to question. This approach also fails to provide a measure of a company's actual current performance but rather measures forecasted performance.

Cash flow return on investment (CFROI) overcomes many of these limitations. It measures the rate at which assets are generating cash flow while explicitly taking into account the distortions caused by inflation, asset age, asset life, and different mixes of depreciating and non-depreciating assets. CFROI spread, the difference between a firm's performance and its market-derived cost of capital, has a much higher correlation with how the market values companies. It has provided a useful insight into Santos' share price performance as well as the efficiency with which the company utilises its asset base relative to other Australian and US oil and gas companies. The CFROI also lends itself to the valuation of individual companies in such a way that it enables meaningful back testing to be performed. Using Santos as an example it was found that the assumptions implicit in this approach are applicable to oil and gas companies.