The Relation of Earning Power to Other Profitability Criteria

Abstract

Abstract One of today's most widely used yardsticks in profitability analysis is rate of return, also known as average annual per cent earning power, or just plain earning power. Its appeal stems from the fact that it combines, in one symbol, both the total return resulting from an investment as well as the distribution of this return over the life of the project created by the investment. One of its drawbacks (which can be eliminated at some expense by an electronic computer) is that it is considerably more cumbersome to calculate than are total profit and payout time, each of which, however, treats only one of the two phases of return from investment mentioned above. The literature is replete with references to earning power and with specific applications of profitability analysis by the use of this method. More often than not the analysis takes as its starting point the discounting of the income stream of a venture until it equals the venture capital. Such a point of departure makes the concept of earning power rather elusive. This paper presents a derivation from simple fundamentals of the earning power concept-with the objective of making the concept more meaningful to its users. During the course of the derivation, certain relationships between earning power and other profitability criteria became apparent, which were considered of sufficient general utility to be included in this report. For ease of application these relationships are presented graphically. Introduction Whereas profit is almost universally defined as all income from a venture less all costs, no such unanimity exists regarding the word profitability. It is proper that this should be so, for under the general heading of profitability are included not only profit, but also a great many other yardsticks, which, when properly weighed, lead to decisions of whether or not to undertake a project, or which one of two possibly dissimilar projects to select. Because different individuals or corporations have different amounts and sources of funds for investment, different investment opportunities and possibly different investment objectives, it is only natural that the general term "profitability" should mean different things to them. Of the almost limitless number of profitability measurements which could exist, there are relatively few in general use. Their weight with respect to each other may differ from corporation to corporation, as may the actually acceptable numerical limits. These profitability criteria include profit, per cent profit, payout time, annual (cash) return on gross investment, annual net return on net (unamortized) investment and various average rates of return on investment one of which we call earning power. Another popular series of criteria are developed by discounting future expenses or income at the cost of money (bank interest rate) or at some desired or acceptable company earning rate. There is a continuing search among economists for one criterion which will properly combine and uniquely express all of the desiderata of management insofar as investment analysis is concerned. Some of the criteria developed to this end are highly sophisticated and in turn some of these-but by no means all-are revealing and therefore useful. Because, as we have stated above, different profit centers have different objectives, it is unlikely that a single profitability criterion will ever find universal acceptance. There is one criterion, however, which combines investment and income stream, profit, payout time and project life, return on investment and present worth, not only in a mathematically elegant manner, but also in a manner which many corporation economists find useful in profit-ability analysis. This criterion is average annual per cent earning power, (abbreviated in this report to earning power) and also known as internal rate of return, true rate of return or just rate of return. Earning power is not being offered here as a profitability criterion which will make all others unnecessary and obsolete. More than one value of earning power can be calculated in certain acceleration projects, and ranking according to earning power can be different from ranking according to, say, minimum acceptable return on investment. Thus earning power has definite shortcomings as a ranking yardstick. JPT P. 269^