Measuring Wealth Creation
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November 16 2011 by JP Donlon
Click here to see a slideshow of the Top 10 Most Valuable CEOs
Click here to see a full list of companies and their respective rankings
Click here to read about the methodology behind the list
Click here to see the Best and the Worst and How to Improve Your Ranking
Recently, we attended a dinner in New York with Joe Echevarria, the freshly minted CEO of Deloitte. As the first Hispanic to run a Big Four professional-services firm, he is refreshingly plainspoken about many things, not least of which are the conventions of the accounting and audit profession. You might have a less than conventional perspective, too, if you grew up in a tough South Bronx neighborhood off the Bruckner Boulevard, where the erstwhile protagonist of “The Bonfire of the Vanities” took a fateful, wrong turn and ended up on the mean streets of Hunts Point.
We suggested to Joe that the accounting profession could do itself and the business world a service by coming up with a more useful standard for measuring value in public companies than the creaky Generally Accepted Accounting Principles (GAAP) standard, a relic of another age hopelessly past its sell-by date. Traditional GAAP practices calculate net income, the so-called bottom line, which is turned into earnings per share (EPS)—a measurement as fallacious as it is ubiquitous. EPS doesn’t reflect true economic value or the kind that an owner who puts cash into a business would recognize. CEOs are hired to create wealth for the owners, yet one cannot use GAAP to measure whether actual wealth is being created.
In 2008, we teamed up with Chicago’s Applied Finance Group, an independent equity, research-advisory firm, and Drew Morris of Great Numbers! to measure real wealth generation among companies in much the same way that an institutional investor or private equity firm would. AFG uses a methodology based on economic margin (EM), which measures the degree to which a company is making money in excess of its cost of capital. The Wealth Creation Index (See page 26), also incorporates other metrics that consider management’s ability to generate shareholder wealth and protect valuable assets. We don’t pretend that EM is the Holy Grail. (There are many strong contenders, such as economic value added (EVA) and market value added (MVA). While not perfect, EM is better than most and has the advantage of counting what really counts. Measures based on accounting profit are prone to distortion and have little relationship to wealth creation.
To my surprise, Joe didn’t argue with this premise; and, to be fair to Joe and his profession, accountants are not intentionally perverse. Their historic purpose is to value assets and the operating condition of the company, to determine residual value under the worst circumstances. They are there to protect bondholders. He spoke of coming international standards but, unfortunately, not everyone around the world agrees on what these standards ought to be. Meanwhile, managers and investors are trying to determine the reality behind the maze of accounting numbers that the SEC compels companies to produce. Therefore, we hope our annual WCI is a step in the right direction.