Profit Maximisation vs Value Maximisation

Profit maximisation asks how large this year's number can be. Value maximisation asks what the whole future stream is worth today. The two answers disagree, and Sankalp Industrial Systems Limited, an invented manufacturer, shows exactly where. The company spends Rs 1,00,00,00,000 of net new capital a year to earn 18.00 per cent against capital costing 12.00 per cent. Stopping that spending would raise next year's profit and lower the worth of the company.

The disagreement is easier to feel at the scale of a sweet shop, so start on a lane rather than in a set of accounts. A halwai has run the same shop for eleven years. At the end of every year he counts what is left in the cash box after everything has been paid, and that figure is how he knows whether the year went well. He is now looking at a second kadhai and a larger cold display, Rs 80,000 for the pair, and his nephew has worked out that the extra capacity would bring in about Rs 14,400 more every year afterwards, once the festival trade is counted.

The awkward part is the whole disagreement inside one household. If he buys them, this year's cash box is Rs 80,000 lighter. On the only measure he has ever used, this year went worse. The shop, meanwhile, now throws off Rs 14,400 a year that it did not throw off before, and it will keep doing that long after the year in which the money left. So the shop is worth more than it was on the first day of the year. Two honest measures of the same twelve months point in opposite directions, and neither of them is lying.

With a price put on the money he used, the second measure stops being a feeling and becomes arithmetic. Suppose the Rs 80,000 could otherwise have sat somewhere earning 12.00 per cent a year, a figure invented for this worked example and used at every step below. Rs 14,400 arriving every year, valued at 12.00 per cent, comes to Rs 1,20,000. He spent Rs 80,000 and picked up something worth Rs 1,20,000, so the purchase left him Rs 40,000 better off at the moment he made it, in a year his cash box records as the worse one. Change the units from thousands to crores, put a board and a set of published accounts around it, and the result is Sankalp Industrial Systems Limited.

What is the difference between maximising profit and maximising value?

Both are objectives. Both are arithmetic. A comparison that has not defined both sides is only an argument, so all three differences are worth naming before either objective is put to work. The two differ in three things and in nothing else. Profit maximisationMaking this year's reported profit figure as large as it will go. takes a single accounting period, adds up what the period earned, subtracts what the period was charged, and asks for the largest possible remainder. Value maximisationMaking the worth of the whole future stream, discounted to today, as large as it will go. takes every year the business will ever have, converts each of those years into cash, pulls each year's cash back to today at a rate reflecting what the money used could have earned elsewhere, and asks for the largest possible sum.

So the first difference is what is counted. A profit figure counts revenue earned and charges incurred inside a window. A value figure counts cash freed up. A rupee of revenue that has not been collected sits in the profit figure and not in the cash, and a rupee spent on a machine sits in the cash and only slowly in the profit, so the two are different quantities.

The second difference is how long. Profit stops at the end of the period and starts again from nothing. Value never stops. A value figure runs to the end of the business and simply counts distant years for less than near ones. The third difference is what gets charged for. A profit figure charges interest to the lenders and charges nothing whatever to the shareholders, whose money is in the business just as firmly and just as expensively. A value figure charges for every rupee of capital inside the business, whoever put it there, at what that rupee could have earned somewhere else of the same risk.

The three differences are the entire difference, and every disagreement between the two objectives, including the expensive one worked below, comes out of one of them. Nothing else about the two is unlike. The two objectives are not rival philosophies of business, not a short view against a long view in the loose way that phrase usually gets used, and neither of them belongs to a particular sort of person. Profit maximisation and value maximisation are two sums with different rules about what is allowed inside them.

Where do the two objectives actually agree, and how often?

Almost always, and this is the part that gets left out of the usual telling. Run through an ordinary month at Sankalp Industrial Systems Limited, invented, and the two objectives return the same verdict on decision after decision. Scrap comes down on the castings line: profit rises because a charge fell away, and value rises because the cash freed up is now larger in this year and in every year that follows. An aftermarket service contract is signed: profit rises, value rises. A facility is refinanced at a lower contracted rate: profit rises because the interest charge falls, and value rises for the same reason. A machine that has earned nothing for three years is sold: profit picks up the proceeds and value picks up cash it was never going to get from running the thing.

The agreement is not a warm-up, and it is not a detail. If the two objectives disagreed everywhere, no company could ever use the profit figure for anything, and the fact that they agree on the overwhelming majority of decisions is exactly why the reported profit figure survives as a working instrument at all. A manager watching the profit line will be steered correctly through most of what crosses a desk in a year.

The agreement also explains why the disagreement is so hard to spot in practice. A measure that is wrong all the time gets abandoned. A measure that is right ninety-something times out of a hundred gets trusted, and then it is trusted on the hundredth occasion too. The hundredth is the one it cannot handle.

Where do the two part company, and is it really only one place?

The two part company in really only one place, and here is why that must be so rather than merely happening to be so. A profit figure and a value figure disagree only when a decision moves cash across the boundary of the accounting period. If everything a decision does happens inside this year, both measures see all of it and both score it identically. The disagreement needs money to leave in one period and return in later ones. One measure then sees only the leaving; the other sees the leaving and the returning together.

There is exactly one everyday activity shaped like that, and companies call it reinvestmentMoney put back into the business rather than paid out or held.. A second valve line, a bigger stock of castings, a longer credit period offered to a distributor who will then buy more: all of them are cash out now against cash in later. Everything else a company does either lands inside the period or is a financing arrangement that both measures treat the same way.

At Sankalp Industrial Systems Limited, invented, that activity has a size, and the same size is used at every step below. In each of five forecast years the company puts a further Rs 1,00,00,00,000 into the business on a net basis, arrived at as capital expenditure less the depreciation charge plus the movement in working capital. The build of that figure is covered separately and is carried here as a given. The comparison needs only that the figure is net new invested capitalCapital expenditure less depreciation plus the movement in working capital., so it is genuinely new capital going into the ground rather than the replacement of what wore out.

Every rupee of that Rs 1,00,00,00,000 is money that leaves in one year and comes back in later ones, and no other line in the whole company can produce a disagreement between the two objectives. The reinvestment line is the argument. The rest of the accounts are common ground.

What single line makes the parting visible?

One subtraction, and it is worth slowing down for. The subtraction shows the whole disagreement without any further machinery. Free cash flow to the firmOperating profit after tax less the net new capital the business needs. is net operating profit after tax less net new invested capital. The full definition is covered separately; the one line of it needed here is that identity.

Now watch what happens when the net new invested capital is the same figure in every year. At Sankalp Industrial Systems Limited, invented, it is Rs 1,00,00,00,000 in each of the five forecast years, so free cash flow to the firm is simply net operating profit after tax less Rs 1,00,00,00,000. One subtraction, done five times.

The first and third columns are two different objectives looking at the same company, side by side in one table. The operating profit after tax column is what a profit measure sees, and it climbs by exactly Rs 18,00,00,000 every year. The free cash flow column is what a value measure works from, and it climbs by exactly the same Rs 18,00,00,000 every year, sitting Rs 1,00,00,00,000 lower throughout. The constant Rs 1,00,00,00,000 gap between the two columns is the price of the growth, and nothing else separates the two objectives anywhere in the forecast.

The arithmetic is easy to over-read, so one caution before going on. The Rs 1,00,00,00,000 is not the company's capital expenditure. Capital expenditure in Year 1 is Rs 1,34,80,00,000, the depreciation charge is Rs 52,80,00,000 and working capital moves by Rs 18,00,00,000, and Rs 1,34,80,00,000 less Rs 52,80,00,000 plus Rs 18,00,00,000 is Rs 1,00,00,00,000. Most of the capital expenditure is simply replacing what wore out. Only the last Rs 1,00,00,00,000 of it is new.

What is the 18.00 per cent actually resting on?

An argument that hides its main assumption has cheated. Before the comparison is run, the assumption doing the heavy lifting has to be put on the table. The forecast says each Rs 1,00,00,00,000 of net new capital produces a further Rs 18,00,00,000 of operating profit after tax a year. The ratio of the two is a return on new invested capitalWhat the money most recently committed earns, which need not match the existing base. of 18.00 per cent. The capital already in the ground earns 15.00 per cent, being Rs 1,80,00,00,000 on Rs 12,00,00,00,000. So the new money is assumed to do better than the old money, and the obvious question is how.

Not through margin. The forecast holds the margin after tax at a flat 15.00 per cent of revenue on old capital and new capital alike, and nothing anywhere in it improves. The difference is entirely in how much revenue a rupee of capital carries. The existing base runs Rs 12,00,00,00,000 of capital against Rs 12,00,00,00,000 of revenue, or 1.00 turn, and 1.00 turn at a 15.00 per cent margin is 15.00 per cent. Each new Rs 1,00,00,00,000 is assumed to carry Rs 1,20,00,00,000 of revenue, or 1.20 turns, and 1.20 turns at the same 15.00 per cent margin is exactly Rs 18,00,00,000, or 18.00 per cent.

So the whole 18-against-15 assumption is a claim about capital turnover and contains no claim about margin whatever, and no evidence for it is recorded anywhere in this worked example. The 18.00 per cent is not a result the model produced; it is an input the model was handed, and every figure downstream of it inherits it. A reader meeting a forecast like this one in the wild should go looking for why the newest rupee is supposed to work harder than the rupee before it, and should be uneasy if nobody can say.

What does cutting the reinvestment do to next year's number?

Cutting the reinvestment improves next year's number, immediately and by a lot, and there is nothing sly about how. Suppose the board decides that next year's reported figure matters more than anything else, and stops the net new spending for a year. The stopped year is a counterfactualA constructed alternative used for comparison, which did not happen and is not a forecast.. The stopped year is constructed from the locked inputs so that the two objectives can be set against each other, and nobody is predicting that the board will do it.

Take the cash first, the cleaner of the two. Year 1 free cash flow to the firm was going to be Rs 98,00,00,000, being Rs 1,98,00,00,000 of operating profit after tax less the Rs 1,00,00,00,000 of net new capital. Stop the spending and the subtraction disappears, so the year frees up Rs 1,98,00,00,000 instead. The rise is 102.04 per cent, and the company has done nothing except not spend.

The reported profit improves too, though more slowly and by less. Machines not bought generate no depreciation charge, and working capital not built up ties up nothing, so from the following year the charges against profit are lighter than they would have been. The effect on the profit line is smaller than the effect on the cash line, and it arrives later, but it points the same way.

On every measure that will be printed, discussed at a board meeting or compared with the year before, this decision was a success, and it took no accounting judgement, no aggressive estimate and nothing anyone would need to conceal. A wrong decision that requires somebody to misstate something gets caught by the people whose job that is. A wrong decision that improves every disclosed number does not.

What does the same cut do to what the company is worth?

The same cut takes a very large amount out of the value, and the size only becomes visible once the consequence is followed past the year in which it was taken. If the company never puts new capital in, its operating profit after tax stops climbing. Operating profit after tax does not fall; it simply stays where it is. Instead of rising by Rs 18,00,00,000 a year from Rs 1,80,00,00,000 to Rs 2,70,00,00,000 by Year 5, it stays at Rs 1,80,00,00,000 in Year 1 and in Year 5 and in every year after that.

Now value that. A business producing Rs 1,80,00,00,000 a year forever and needing no new capital to do it is a level streamA cash flow that repeats at the same amount indefinitely and never grows., and a level stream at 12.00 per cent is worth the annual amount divided by 0.12. Rs 1,80,00,00,000 divided by 0.12 is Rs 15,00,00,00,000. Against that, the company's own discounted cash flow with the reinvestment left in comes to Rs 21,28,13,79,094, a figure built separately and carried here as a given. The figure is quoted to the rupee only because the subtraction below is done on the unrounded values; on an answer of this size the last few digits carry no information at all.

The difference between the two is Rs 6,28,13,79,094. Cutting the reinvestment frees up Rs 1,00,00,00,000 of cash next year and gives up Rs 6,28,13,79,094 of company value, and both of those figures come out of the same single forecast.

Two honesty notes travel with that comparison. The first is that Rs 15,00,00,00,000 is a constructed alternative, not a valuation of anything: it assumes the existing base keeps producing Rs 1,80,00,00,000 for ever, needs no net new capital to keep doing it, and never grows even with inflation. Change any of those and the figure moves. The second is that the Rs 21,28,13,79,094 carries the 18.00 per cent assumption examined above, plus a whole terminal value built separately, so it is no more solid than its inputs. The comparison establishes a direction and an order of magnitude, and nothing finer than that.

How large is each of the two figures, set side by side?

Very different sizes, and setting them next to each other is exactly why both were computed. On one side is the Rs 1,00,00,00,000 of cash the company keeps next year. On the other is the Rs 6,28,13,79,094 of value it gives up. The second is a little over six times the first, and the second is the one that never appears in a set of accounts.

Think about why the accounts cannot show it. An accounting system records transactions that happened. Postponing the spending is not a transaction. Nobody sold anything, wrote anything off or paid anything away. The value given up is the difference between the company that exists and a company that would have existed had a different decision been taken, and no ledger anywhere records a company that did not happen. The gain is a transaction and the loss is a comparison. One of them is therefore auditable and the other invisible.

Is there a smaller version of the same comparison?

There is, and it needs no forecast and no terminal value and it fits inside a paragraph, so it deserves reaching for more often than the big one. Take a single year's decision on its own. The company spends Rs 1,00,00,00,000 of net new capital. On the forecast's assumption that money earns 18.00 per cent, so it buys Rs 18,00,00,000 a year. Valued at 12.00 per cent, a stream of Rs 18,00,00,000 a year is worth Rs 1,50,00,00,000. The company paid Rs 1,00,00,00,000 for something worth Rs 1,50,00,00,000, and that single year's decision therefore created Rs 50,00,00,000.

Notice what just happened to the profit test. In the year that Rs 50,00,00,000 of value was created, the company's free cash flow was Rs 1,00,00,00,000 lower than it would otherwise have been. The best decision available produced the worst-looking year, and the worst-looking year is the one that gets reported, discussed and compared.

Two figures now stand side by side and they are easy to confuse. Rs 50,00,00,000 is what one year's spending creates. Rs 6,28,13,79,094 is what stopping the spending altogether and for ever gives up. The two figures measure different things, both are computed from the same locked inputs, and any note or paper quoting one of them owes the reader a sentence saying which. The first is a decision. The second is a strategy.

The Rs 50,00,00,000 also carries an assumption worth staring at. Turning Rs 18,00,00,000 a year into Rs 1,50,00,00,000 assumes the Rs 18,00,00,000 keeps arriving indefinitely. Assume instead that it runs for ten years and then stops, and the figure falls a long way. Nothing in this worked example settles which is right, and a reader who takes the Rs 50,00,00,000 without noticing the perpetuity inside it has taken the strongest possible version of the claim.

What are the three things a profit figure does not charge for?

Three, and they are three separate omissions rather than three ways of describing one. A reader who can name all three can look at any profit figure anywhere and say what is missing from it, so the three are worth having as a list.

The first is the capital chargeThe cost of capital multiplied by the capital used.. A profit and loss account deducts the interest paid to lenders and deducts nothing at all for the money shareholders left in the business. At Sankalp Industrial Systems Limited, invented, the capital in the business at Year 0 is Rs 12,00,00,00,000 and it costs 12.00 per cent, or Rs 1,44,00,00,000 a year. Set that against operating profit after tax of Rs 1,80,00,00,000 and what is left over is Rs 36,00,00,000, a figure settled separately and carried here as a given. Rs 1,44,00,00,000 of real cost appears in no row of any statement the company publishes.

The second is timing. A profit figure treats a rupee arriving in Year 5 as identical to a rupee arriving next year. At 12.00 per cent they are not identical: Rs 18,00,00,000 arriving in Year 5 is worth Rs 10,21,36,834 today, a little over half. Why that is so, and how the conversion is done, belong to a subject covered separately; what is needed here is only the fact that a profit figure does not do it.

The third is certainty. Two companies can report exactly the same Rs 1,38,00,00,000 of profit attributable to owners, one from a long contracted service book and the other from a single order that may not repeat, and their accounts will look the same. A value figure charges for that difference through the rate it discounts at. A single period's arithmetic has nowhere to put risk, so a profit figure has no mechanism for charging for it at all.

Is there a case where cutting the reinvestment raises the value too?

Yes, and without that case a reader walks away with the wrong rule, so the comparison is not properly understood until it has been seen. The wrong rule is that reinvesting is good and cutting it is bad. It is not.

Change one input and nothing else. Suppose new capital at Sankalp Industrial Systems Limited, invented, earned 10.00 per cent instead of 18.00 per cent, against the same 12.00 per cent cost of capital. Then Rs 1,00,00,00,000 of new spending buys Rs 10,00,00,000 a year, and Rs 10,00,00,000 a year at 12.00 per cent is worth Rs 83,33,33,333. The company would have paid Rs 1,00,00,00,000 for something worth Rs 83,33,33,333, destroying Rs 16,66,66,667 with every year's spending.

Now run the cut again in that world. Stopping the spending frees up Rs 1,00,00,00,000 of cash next year, exactly as before, so the profit test still says do it. And it stops the company paying Rs 1,00,00,00,000 for Rs 83,33,33,333 of value, so the value test says do it as well. The two objectives now point the same way, in the opposite direction from before.

Growth is not good in itself, and this is the sentence the whole comparison exists to earn: reinvestment creates value when what the new capital earns exceeds what that capital costs, and destroys value when it does not. A company growing fast on capital earning below its cost is getting smaller in the only sense that matters, however impressive the revenue line looks. The direction of the disagreement between the two objectives is not fixed. The direction flips at one identifiable point, and that point is the cost of capital.

Which of the two is the objective, and which is the measure that gets reported?

Value is the objective. Profit is the measure that gets reported. The ordering is not a preference. Whose value is being maximised, over what length of time and subject to what constraints are covered separately. The narrower question settled here is which of the two is the right target for the arithmetic, and the answer follows from the three charges. A measure that leaves out the cost of the capital, the timing of the money and the certainty of the money can be improved by getting worse at all three. A measure like that cannot be the target.

So why does the reported profit figure carry so much weight in practice? Because it exists. The profit figure is produced on a schedule, it is audited, it is comparable with last year and with other companies, and it can be put in a headline. The value figure exists only as somebody's estimate, moves when an assumption moves, and cannot be audited because there is nothing to audit. Between a rough measure of the right thing and a precise measure of the wrong thing, organisations reach for the precise one, and then the precise one starts steering the organisation.

None of the three omissions makes the reported profit figure wrong; together they make it the wrong thing to maximise. The profit figure remains the best available summary of what a period actually did. Every valuation in existence starts from it. The mistake is not reading it. The mistake is treating a number that omits three separate charges as though it were the objective.

What goes wrong when an earnings target is met by underspending?

How does a lender, an analyst or an owner actually use this?

Three readers pull three different things off the same comparison, and it is worth seeing all three, because this arithmetic is used far more often than it is taught.

A lender uses it as a warning about cash that is about to stop being available. A borrower whose capital expenditure has fallen below its depreciation charge is generating flattering cash today by not replacing its own asset base, and the replacement is not cancelled, only postponed. The lender's exposure runs for years, so a borrower who has spent three years underspending is a borrower whose next three years carry a spending catch-up the current cash figure does not show. A credit paper that quotes cash flow without setting capital expenditure against depreciation beside it has therefore left out the part that matters most to the person lending.

An equity analyst uses it in the opposite direction, as a check on whether a jump in a profit line was earned or merely arranged. A company reporting a better year with capital expenditure sharply down has produced improvement of a kind that cannot be repeated. The trick can only be done once before the asset base starts to complain. The analyst's question is not whether the profit rose. The question is whether the capital base rose with it. The comparison converts an unanswerable question about management intent into an answerable question about two published numbers.

An owner of a small business uses it on the same day of every year, usually without calling it anything. The halwai at the opening faces exactly this arithmetic every time he chooses between taking money home and putting it back into the shop, and the only reason a company version is harder is that the person making the choice is not the person whose money it is. The separation, and its effect on the decision, is covered separately. The comparison settles that the two available answers can be ranked, and how the ranking is done.

One last practical note for a reader with no data service and no model. Most readers have neither. Every number needed for this check is in a published annual report: the capital expenditure line in the cash flow statement, the depreciation charge in the profit and loss account, and the same two figures for the four prior years. No estimate, no rate and no assumption is needed to run the comparison. The judgement only starts afterwards.