Rethinking the Value of 3 Common Financial Metrics

Most companies use too many incomplete measures and would benefit from
using one complete measure instead, as railroading company CSX has

At a recent financial training session for railroading company CSX
Corporation, CFO Sean Pelkey asked his teammates to list what they
considered to be the three most important financial measures. The
purpose was to consider both the merits and shortcomings of each
measure and ultimately examine how they may lead to suboptimal

Pelkey used this exercise to introduce CSX’s new financial measure,
CSX Cash Earnings (CCE). As the company wrote in its March 2022 proxy
filing with the SEC, “The transition to CCE is designed to measure
whether returns on new investments exceed an expected rate of return
and to encourage investments in growth projects. Based on back-testing
of historical data, CCE has shown a high correlation to stock price

In simple terms, CCE is a cash-based economic profit measure that
starts with operating income, adds depreciation, and subtracts taxes.
The result is what we call gross cash earnings, a pre-tax, adjusted
version of EBITDA (earnings before interest, taxes, and depreciation),
from which a capital charge is subtracted for the use of the assets
invested in the business. The capital charge is determined by
multiplying the average amount of gross operating assets by the
required return on capital, which is an estimate of the aggregate
return expected by investors and lenders.

How To Improve Cash Earnings

There are three straightforward ways the company can improve CCE. The
first, improve cost efficiency and capital productivity, which have
fueled substantial success at CSX in recent years. Second, eliminate
unneeded assets to free up capital that can be reallocated to more
productive activities, which, again, has been a core competency.
Third, invest in new activities that exceed the required return on the
capital invested in them. Using this new measure, CCE is helping CSX
achieve more growth, without losing its focus on cost efficiency and
capital productivity.

Back to the session — 15 measures were listed by the 30 CSX attendees.
One by one, Pelkey explained the merits and shortcomings of each. The
top metric was free cash flow — unsurprisingly since it had featured
in CSX’s long-term incentive plan as a way to drive capital discipline
in recent years. Free cash flow is a term originally coined in the
1970s by my former partner, Joel Stern. Although the measure has had
many definitions applied to it over the years, the original was simply
cash in, less cashout, excluding all flows related to financing
activities. Stern used to describe it as the cash that is freely
available to the debt and equity providers of capital.

When business students take courses in corporate finance, they learn
about the so-called discounted cash flow valuation model, which holds
that the value of a company is the present value of its expected
future free cash flow. We don’t need to understand all the math to see
that free cash flow would seem to be a pretty darn important
performance measure if it is directly linked to the value of the

Free cash flow can be an obstacle to growth since new investments
detract from the measure in all cases except when return on investment
exceeds 100% in the first year — a high bar.

Yet, as Pelkey pointed out to his colleagues, free cash flow had been
a suitable performance measure when the main focus was cost efficiency
and capital productivity but would not be as helpful with the
increased focus on growth. In fact, free cash flow can be an obstacle
to growth since new investments detract from the measure in all cases
except when return on investment exceeds 100% in the first year — a
high bar. So, while free cash flow is helpful as a period performance
measure, a company is unlikely to achieve meaningful growth by
maximizing each year’s free cash flow. Too many good investments will
be turned down.

The second most mentioned measure was revenue growth, which was
expected since CSX is seeking to boost growth. And growth is highly
important — indeed our 2022 Fortuna Advisors Value Leadership Report
showed a strong relationship between revenue growth and share price

But as Pelkey pointed out, growth for growth’s sake is
counterproductive. And as with free cash flow, one must consider the
unintended consequences of incomplete measurement. The stock market is
littered with companies that went all-in on growth and lost control of
costs, in the end harming their shareholders and other stakeholders
alike. CSX is determined to maintain discipline while they grow,
maintaining cost efficiency and capital productivity. They realize
this approach may slow the pace of growth, but it also reduces the
chances of value-destroying investments.

The next metrics were operating ratio and operating income. Operating
ratio is measured as cost as a percent of revenue and has been an
important driver of success across the railroad industry. And while it
drives focus on cost efficiency, it does not factor in growth.
Operating income, on the other hand, captures revenue less operating
cost, which can benefit from growth, but the metric still ignores the
amount of investment needed to produce the income.

Clarifying Decisions and Tradeoffs

At the end of the session, it was easy for the trainees to see how
CCE, which combines and balances traditional, one-dimensional
measures, would clarify decisions and tradeoffs. For CSX, a measure
that strikes a smart balance of growth and efficiency provides greater
clarity and conviction in corporate decision-making. And it is helping
CSX align the many functions of the organization on a comprehensive
metric, supporting the company’s efforts to encourage employees to act
for the good of the company, often by thinking like investors

Over the last three decades, I have seen companies quickly
transitioning from a heavy emphasis on efficiency and productivity to
a growth mindset, and they often lose discipline and earn inadequate
returns on investments. Transitioning does not have to be a choice
between efficiency or growth. We can have both, and I commend CSX for
implementing a solution that encourages growth investments, but only
when they earn an adequate return.

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