Adjusted economic dividend

What Is Adjusted Economic Dividend?

The Adjusted Economic Dividend refers to a measure of a company's true economic profit, reflecting the surplus value generated beyond all costs, including the opportunity cost of capital. This concept is closely aligned with Economic Value Added (EVA) and economic profit, which are key metrics within the broader field of Financial Performance Measurement. While not a universally standardized term, "Adjusted Economic Dividend" emphasizes the idea of a genuine economic surplus available to shareholders or for reinvestment, after accounting for the full cost of utilizing capital. It seeks to provide a more comprehensive view of value creation than traditional accounting metrics.

History and Origin

The foundational principles behind the Adjusted Economic Dividend, rooted in the concept of economic profit, have a long history in economic theory. However, the modern application and popularization of a similar metric, Economic Value Added (EVA), can be attributed to the consulting firm Stern Stewart & Co. (now Stern Value Management). Joel Stern and G. Bennett Stewart III played a significant role in refining and commercializing EVA in the 1980s and early 1990s, aiming to provide a clearer picture of shareholder value creation than traditional accounting measures. Stern Value Management's history indicates that their team developed EVA in 1983 as a model for maximizing value and providing incentives within firms.⁶ This measure was designed to address the shortcomings of conventional accounting profits by incorporating the cost of capital.

Key Takeaways

• The Adjusted Economic Dividend represents a company's true economic profit, accounting for both explicit and implicit costs, including the cost of capital.
• It is fundamentally aligned with the concept of Economic Value Added (EVA), which measures the residual income generated after deducting the capital charge.
• A positive Adjusted Economic Dividend indicates that a company is creating shareholder value beyond the minimum required return on its invested capital.
• The calculation involves adjustments to conventional financial statement figures to better reflect economic realities.
• This metric encourages managers to allocate invested capital efficiently and focus on long-term value creation.

Formula and Calculation

The calculation for the concept underlying the Adjusted Economic Dividend, Economic Value Added (EVA), involves subtracting the capital charge from the company's net operating profit after tax.

The formula is expressed as:

Where:

• NOPAT (Net Operating Profit After Tax): This is the profit generated from a company's core operations after deducting taxes, but before accounting for financing costs. It can be calculated as Earnings Before Interest and Taxes (EBIT) multiplied by (1 - tax rate).
• Invested Capital: Represents the total capital employed by the business, including both debt and equity. It's often adjusted to reflect the true economic capital.
• WACC (Weighted Average Cost of Capital): This is the average rate of return a company expects to pay its investors, including both debt and equity holders. It represents the minimum rate of return a company must earn on an existing asset base to satisfy its creditors, bondholders, and owners. The Weighted Average Cost of Capital (WACC) is a crucial input in this calculation.

The term ( \text{Invested Capital} \times \text{WACC} ) is often referred to as the "capital charge," representing the total dollar cost of capital utilized by the business. The concept emphasizes that a company only creates economic value if its Net Operating Profit After Tax (NOPAT) exceeds this capital charge.

Interpreting the Adjusted Economic Dividend

Interpreting the Adjusted Economic Dividend (or EVA) is straightforward: a positive value indicates that a company is generating wealth for its owners beyond the return required by its capital providers. This signifies that the business is earning more than its cost of funding, effectively creating economic value. Conversely, a negative Adjusted Economic Dividend implies that the company is not covering its full cost of capital, thereby destroying value.

For instance, if a company has a positive Adjusted Economic Dividend, it means the returns on its projects and operations are exceeding the minimum acceptable rate of return for its investors. This surplus can be viewed as the "dividend" or additional value created. Analysts and managers use this metric to assess a company's true economic performance and its efficiency in utilizing its invested capital. It provides a more accurate picture of wealth creation by taking into account the full economic costs, including the opportunity cost of employing capital in one venture over another.

Hypothetical Example

Consider "GreenGrowth Inc.," a sustainable energy company. In the last fiscal year, GreenGrowth Inc. reported a Net Operating Profit After Tax (NOPAT) of $50 million. The company has $400 million in invested capital, and its Weighted Average Cost of Capital (WACC) is determined to be 10%.

To calculate the Adjusted Economic Dividend (using the EVA framework):

In this scenario, GreenGrowth Inc.'s Adjusted Economic Dividend is $10 million. This positive figure indicates that the company generated $10 million in economic profit above the cost of the capital it employed. This suggests that GreenGrowth Inc. is successfully creating value for its shareholders, as its return on invested capital exceeds its cost of capital. This provides a more robust assessment of financial performance than simply looking at accounting profit.

Practical Applications

The concept of an Adjusted Economic Dividend, through its alignment with Economic Value Added (EVA), finds numerous practical applications across various facets of corporate finance and investment analysis. Companies use it internally as a performance metric to measure the value generated from their invested capital. This helps in strategic decision-making, encouraging management to undertake projects that genuinely create value above their cost of funding.

For example, large global corporations like Coca-Cola, Siemens, and AT&T have adopted EVA as a primary performance metric, demonstrating its utility in corporate decision-making and resource allocation.⁵ It can guide capital budgeting decisions by prioritizing projects with a positive Adjusted Economic Dividend. Furthermore, it is employed in designing executive compensation plans, aligning managerial incentives with shareholder wealth creation. By linking bonuses directly to improvements in this metric, companies aim to foster a culture of value-based management. Investors also consider this measure to evaluate a company's ability to generate sustainable returns and create long-term shareholder value. Unlike traditional accounting figures, it provides a comprehensive view of profitability by factoring in the cost of all capital, whether debt or equity, which is crucial for a complete valuation.

Limitations and Criticisms

Despite its advantages, the concept of an Adjusted Economic Dividend (or EVA) is not without limitations and criticisms. One significant challenge lies in the numerous adjustments required to transform traditional balance sheet and income statement figures into economically meaningful ones. Stern Stewart & Co. itself has suggested a large number of such adjustments, which can be complex and subjective. This complexity can make the calculation difficult and potentially introduce estimation errors, particularly in determining the Weighted Average Cost of Capital (WACC) or adjusting invested capital.

Some research indicates that while EVA has merits, it may not always outperform traditional accounting measures in explaining stock returns, especially in certain market conditions or for companies with significant intangible assets.⁴,³ For instance, companies heavily reliant on intangible assets, such as technology businesses, may not be ideal candidates for an EVA evaluation, as it heavily relies on invested capital, which can understate the true value of such businesses. Furthermore, critics argue that focusing solely on a single metric like the Adjusted Economic Dividend might lead to a short-term managerial focus if not properly balanced with other strategic objectives. The ability of the Adjusted Economic Dividend to be a universal financial metric across all markets, particularly unstable ones, has also been questioned in academic literature.²

Adjusted Economic Dividend vs. Accounting Profit

The primary distinction between the Adjusted Economic Dividend (or economic profit) and accounting profit lies in how each accounts for the cost of capital. Accounting profit, typically reported on a company's income statement, is calculated as total revenue minus explicit costs (e.g., wages, rent, raw materials, interest, and taxes). It focuses on historical costs and actual financial transactions.

In contrast, the Adjusted Economic Dividend, through its alignment with economic profit, deducts both explicit costs and implicit costs, most notably the opportunity cost of the capital employed.¹, This means it considers the return that investors could have earned if their capital were invested in an alternative venture of similar risk. A company can show a positive accounting profit but still have a negative Adjusted Economic Dividend if its profit is not sufficient to cover the cost of all capital used. Therefore, while accounting profit indicates a company's historical financial gain, the Adjusted Economic Dividend aims to reveal the true economic value created above and beyond the minimum required return for its capital providers.

FAQs

Q1: Is Adjusted Economic Dividend the same as Economic Value Added (EVA)?
A1: The term "Adjusted Economic Dividend" is not a standard financial term, but it aligns closely with the principles of Economic Value Added (EVA) and economic profit. Both concepts aim to measure the true economic surplus generated by a business after accounting for the full cost of capital, including the opportunity cost.

Q2: Why is the cost of capital important in calculating the Adjusted Economic Dividend?
A2: Including the cost of capital is crucial because it represents the minimum return expected by investors for the risk they undertake. Without accounting for this, a company might appear profitable on paper (accounting profit) but actually be destroying economic value if its returns don't cover the true cost of using that capital.

Q3: Can a company have a positive accounting profit but a negative Adjusted Economic Dividend?
A3: Yes, this is a key scenario where the Adjusted Economic Dividend (or economic profit) provides a deeper insight. A company can report a positive accounting profit if its revenues exceed its explicit costs. However, if that profit is not high enough to cover the implicit cost of capital (what investors could have earned elsewhere), then the Adjusted Economic Dividend would be negative, indicating that the company is not creating economic value.

Q4: How does the Adjusted Economic Dividend help in management decisions?
A4: By focusing on the Adjusted Economic Dividend, managers are incentivized to make decisions that not only generate revenue but also efficiently utilize invested capital. This encourages them to pursue projects that yield returns greater than their cost of capital, thereby creating genuine value for shareholders and aligning management actions with the goal of maximizing shareholder wealth.