Not All Profits Are Created Equal
- Apr 01, 2005
- admin
- Investing
NOT ALL PROFITS ARE CREATED EQUAL.
As a matter of fact, ONE company could earn BILLIONS of DOLLARS
in Profit and NOT create any real value for shareholders.
While another company could earn $100 million in Profit and
create tremendous value for shareholders.
How could this be, you ask?
It has nothing to do with bad accounting.
It’s all about the difference between “Accounting” Profit
and “Economic” Profit.
And that involves the “Cost-of-Capital.”
Let me explain:
The cost-of-capital is the amount that it cost a company
to utilize the capital it has.
Here’s a simple but revealing example.
Let’s say that you owned a company that had $1,000 in capital.
And all of the capital was debt that you borrowed at 5 percent.
That means that your cost-of-capital would be $50 per year.
That would be your “hurdle” rate.
So, let’s say that one year you earned $75.
That means you had an ECONOMIC PROFIT – a profit above your
cost-of-capital – of $25.
Now let’s say that the following year you earned $20.
While you would still have an ACCOUNTING PROFIT OF $20,
you have an ECONOMIC LOSS of $30.
In other words, you would have EARNED LESS than the amount
it costs you to USE THE CAPITAL!
So, what does this have to do with Old Iron Fist?
Plenty.
You see, Sumner Redstone, is beginning to learn what his
cost-of-capital is.
After years of getting large for the sake of size and
years of doing deals for the sake of cash flow only, he’s
learning.
Let me explain:
He’s debating whether to break Viacom in two.
One company – called “Cable Networks” – will include MTV
and Nickelodean.
The other company – called ‘Broadcast” – will include
Infinity Broadcasting and CBS.
And therein lies the clue to judge which group has a higher
ECONOMIC PROFIT.
You see, the Broadcast group is in an industry that is in
decline.
Sure, CBS and Infinity earn BILLIONS in ACCOUNTING PROFITS,
but they really don’t earn ECONOMIC PROFITS.
I know, I know – that’s a hard concept to swallow.
To earn BILLIONS in Net Income and NOT create real value
for shareholders.
But think about it for a moment – if you earn $3 BILLION in
net income and it cost you $3 BILLION to do that, have you
added any REAL VALUE?
Not by a long shot.
In contrast, fast growing MTV and Nickelodeon earn
both ACCOUNTING PROFITS AND ECONOMIC PROFITS.
And that’s why Old Iron Fist will end up splitting his
company in two.
Companies that earn ECONOMIC PROFITS ARE VALUED MUCH HIGHER
THAN COMPANIES THAT DON’T.
And based upon projections, it might mean that Mr. Redstone
will increase his net worth by $2 Billion alone just by
unlocking the value in his companies.
–Dylan Jovine