What is Residual Cash Earnings (RCE)?
Residual Cash Earnings, or RCE, is a comprehensive financial performance measure. It is designed to capture the three primary drivers of shareholder value simultaneously: growth, margin, and asset utilization .
The metric is calculated as:
Gross Cash Earnings (defined as essentially after-tax EBITDA)
Less a Capital Charge (reflecting the expected return shareholders and lenders require for the use of the company’s Gross Operating Assets).
RCE is similar to Economic Profit, but as Milano’s article notes, it typically explains market valuation better because it is based on cash flow and undepreciated assets. From my perspective as an investor, this focus on cash and total capital deployed is far more revealing than traditional accrual accounting.
Why is RCE Superior for Tech Companies?
The article’s authors argue that traditional accounting is “worthless” for evaluating tech companies because it penalizes them for R&D spending, their primary driver of growth.
The RCE framework is customized for tech and other R&D-intensive firms by treating R&D as an investment . This adjustment imposes accountability for earning adequate returns on the investment.
- Concrete Stat: This methodological shift is not just academic. The article’s 2015 analysis found that when R&D is appropriately treated as an investment, the median RCE margin for tech companies was 15.5% . This was 2.5 times the 6.3% median for the remaining 1,000 largest U.S. non-financial companies.
- Critical Insight: This single adjustment proves that, when measured correctly, technology companies are “actually much more profitable than the rest of the market”. It aligns the financial model with the business reality: R&D is an investment in a future-generating asset, and RCE holds managers accountable for earning a return on that investment.
How Does RCE Link to Shareholder Value (TSR)?
The most compelling evidence in the article comes from a capital market study linking RCE to Total Shareholder Return (TSR). The study found that the change in RCE correlates with TSR better than any other metric the authors tested.
The key is focusing on improvement, not the absolute level. The article notes that increasing RCE from -80 to -30 creates just as much value as raising it from 20 to 70.
RCE Improvement vs. Total Shareholder Return (TSR)
The study divided companies into high- and low-RCE-improving groups over three years. The results were stark:
| Metric Comparison | High-RCE-Improving Companies | Low-RCE-Improving Companies |
|---|---|---|
| Median RCE Improvement | 15.1% (of beginning gross operating assets) | -2.0% (a decline) |
| Median TSR | 19.1% | 4.7% |
| TSR Difference | 14.4% |
This 14.4% gap in median TSR was the highest performance difference found in the study, providing “substantial evidence” that increases in RCE lead to higher TSR. This aligns with my experience in value-based management: what gets measured and rewarded is what gets done.
What are the Benefits of RCE for Managers and Investors?
Milano’s article outlines a clear, “Moneyball”-like case for RCE by showing how it benefits both management and shareholders.
For Managers:
- Better Decisions: It simplifies complex tradeoff decisions. For example, if an investment increases growth by 2% but reduces the rate of return by 1%, the clear test is: does the rise in investment RCE? If the incremental gross cash earnings are adequate to more than cover the expected return on the incremental capital, then RCE increases and the investment is sound.
- Fairer Compensation: It ends “the budget or target negotiation game”. By tying compensation to improvement versus the prior year, RCE gives managers a “simulated ownership position”. They are rewarded for creating excess value, just as an owner would be.
For Investors:
- Proper Alignment: Investors know managers are motivated “to treat the investors’ money as if it were their own”.
- Long-Term Focus: It discourages short-term actions that have negative long-term consequences. Any artificial, short-term boost to RCE will be “mitigated” by “inevitable RCE declines” and reduced bonuses in later years.
- Accountability: If management invests in a project that fails to meet the required return on capital, RCE will decline, and so will their compensation.
- Critical Insight: This system creates the accountability needed to improve judgment. It fosters a fact-based discipline for making decisions based on data and evidence rather than just “gut feel or historical norms”.
Expertise Reinforcement and Clear Next Action
In my nearly 40 years as an investor and portfolio manager, I have seen countless metrics used to justify performance. The RCE framework presented by Gregory V. Milano and Fortuna Advisors is among the most robust I’ve encountered for aligning management incentives with sustainable shareholder value creation. It uniquely solves the problem of measuring R&D-driven businesses, making it essential for a tech-dominated market.
For investors and managers seeking to apply this, the path forward involves a shift in perspective.
A Decision-Making Framework Based on RCE:
- For Investors Analyzing Tech: Look beyond EPS and EBITDA margins. Ask if the company measures or reports on its return on R&D. Use the RCE concept to evaluate whether the company’s growth is “funding itself” by generating returns above its cost of capital.
- For Managers and Boards: Stop managing to negotiated budgets or simple growth targets. Begin integrating RCE into your internal planning, budgeting, and performance measurement. The goal is to reward managers for improving year-over-year value, not just hitting an arbitrary number.
- For Deeper Analysis: I recommend reading the original article in CFO.com and exploring the work of Fortuna Advisors. The shift to a value-based management model is a process, but as the article’s data shows, it is a profitable one.
