According to at least some people, the goal of a capitalist corporation is to maximize the wealth of its owners, within legal, ethical, political, and perhaps more limits of course.
The wealth of its owners can be measured by period profits, which is the maximum dividends paid, and/or shareholder value, which is the market value of the company’s shares. Profit (the number of earnings measured) and Shareholder Value: are two different phenomena, each with their own merits.
Also, cash flow and profit are two different phenomena. No cash flow is able to make up for the error related to the winning number. What has been argued by so many people, eg Pablo Fernandez (on SSRN_ID330540: the saying ‘profit is an opinion, money is a fact’) is not true. It’s the other way around. With The Profit Formula®, the profit for the period can be measured exactly.
Different authors hold different opinions on what “cash flow” is. According to some people, profit is not so important, more important is the creation of shareholder value. Both terms, “period profit” and “shareholder value”, are not contradictory views, but are mostly in direct line with each other. Shareholder value is based on cash flows related to selling prices, and those cash flows don’t tell the whole story.
The period profit is the realized value; it’s the extra that comes at the end of a period beyond what was there at the beginning. The shareholder value, the value of a company, is at any point in time the present value (PV value) of all future earnings less loans and short-term liabilities; It’s the price people are willing to pay for the entire company at any given point in time if they expect promising profits. While creating more shareholder value is also very important, it’s different than profit for the period.
The PV value will remain constant over time, of course in a stable situation when replacing exactly the consumed items. Earned profits – above a certain amount – are not to be despised. A boring business, yes. The cow does not grow, but constantly gives a bucket filled with milk.
To quote an old banker: “Good deals are boring deals.” A fund for widows and orphans, perhaps, but such a fund still has a prominent place on the stock exchange’s official list. Speculators are looking for bulls and bears, those companies whose PV values are changing rapidly. Imagine a rapidly growing calf, no milk yet, promises only for the time being. Something from such a growing calf farm cow may become a write-off or otherwise lost, but that same something can be replaced immediately (at true replacement cost) and henceforth no one will see the difference.
The value of the replaced device, the value of that asset, part of the total balance is not based on the PV value. The total balance can be based on any valuation basis, but is not usually based on the PV value. At no point in this entire story is PV value at stake. birds in the bush. Not in hand yet. When properly interpreted, the exploitation principle defines what profit is. Profit is like milk. After milking there is milk; the milking stool seems to have three legs: people, planet and profit. Before milking there are expectations, promises, changing PV values, whatever, but no milk. Profit is an ex post entity. Profit forecasts and forecasts can be made ex ante. However, the winner can only be determined ex post. Ex post, in hindsight, one can of course calculate a difference of two shareholder values at the beginning and at the end of a period under consideration. An increase is often better than a decrease. What does the difference mean in a specific situation?
The company can become a small business that is still profitable. Shareholder value (economic value: what could happen in addition to existing activities?) and overall balance (embedded value: what is really there?) are snapshots, ie parameters with one value at a time, while profit is a period parameter. Profit for the period and shareholder value are separate but related. They relate to each other, strengthen or weaken and vice versa, but it’s a loose relationship. One cannot take the place of another. It is possible to keep the same level through (additional) investments or to increase the PV value (Shareholder Value), after which a (more) profitable company survives. PV value is based on cash flows related to selling prices, and those cash flows don’t tell the whole story.
There’s still something between cash flow and profit, and that something can be a lot. High(er) cash flows can very well go hand in hand with lower(er) profits. An increase in PV value can be achieved through better investments. Higher PV values and higher gains usually go together. An increase in PV implies promises, expectations. Proving them, fulfilling them, is another matter. Future profits will be the proof. Conversely, bad investments, lower PV values and the future look bleak. By measuring later period profits as accurately as possible after investments are made, one can have the company at one’s fingertips. triggering the entire operation. With the tiniest little indicator one can give adequate guidance for the adjustment required. By not knowing the real period profit, you lose control.
For more than what is noted in this article, see my free downloadable article “Period Earnings, Shareholder Value, Share Capital, EVA®, CVA®, NVA and Cash Flow – Different Terms Each With Their Own Peculiarities”. http://ssrn.com/abstract=394140
Written by Jan Jacobs.
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