Establishing a Baseline EP
The ideal performance measure will track value creation the way a thermometer shows temperature, i.e., by increasing when value is being created, and shrinking when value is being destroyed. But unlike temperature, a corporate performance measure should be safe to maximize from the owners' perspective. In other words, the bigger the number, the more value that the company likely created.
No single accounting-based measure can perfectly meet those criteria. But certain financial or non-financial measures can indicate value creation reasonably well depending on the circumstance. For instance, in a new product release where the incremental cost of making and delivering that product is nominal, revenue growth might be an excellent gauge of value creation. If the product has significant unit costs associated with its production or delivery, then gross margin might be the right measure. If one is developing a new technology, and mass customer acceptance is the key value driver, then some volume-of-sales measure may best indicate value creation, while trying to maximize revenue or profit in the near term may be counterproductive.
Adopting EP as a measure presumes that returns relative to the cost of capital over periods of less than two years is a reliable indicator of value creation. This is generally true for any business comprising primarily of assets with proven revenue-generating capacity, or a reasonably stable business model with established operations.
The first step in determining EP is to calculate a Baseline EP, as measured more or less directly from the company's existing financial statements. In the upcoming slides, we will show how to do this.
