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Adjusted economic premium

What Is Adjusted Economic Premium?

Adjusted Economic Premium represents a refined measure of a company's true profitability, moving beyond traditional accounting profit to capture the economic value created. It is a concept within corporate finance and financial performance measurement that aims to provide a more comprehensive view of how efficiently a business uses its capital. Unlike accounting profit, which primarily considers explicit costs and revenue, the Adjusted Economic Premium factors in both implicit costs, notably the opportunity cost of capital, and applies further specific adjustments to better reflect economic realities or strategic objectives. This focus allows businesses to assess whether their operations are generating returns above and beyond the minimum required by their investors, considering all resources consumed, tangible and intangible.

History and Origin

The concept of economic profit has roots dating back centuries, with economists long recognizing that true profitability must account for the alternative uses of capital. However, its practical application in corporate management gained significant traction in the latter half of the 20th century. A major catalyst for this shift was the popularization of Economic Value Added (EVA™) by the consulting firm Stern Stewart & Co. in the early 1990s. Joel Stern and G. Bennett Stewart III were instrumental in commercializing this metric, which they designed to align management incentives with shareholder value creation. Stern Stewart & Co., now Stern Value Management, was incorporated in 1982 and developed EVA as a model for maximizing value and providing incentives throughout a firm.

8EVA involves making a series of adjustments to conventional accounting figures to convert them into a more economically accurate measure of profit. These adjustments often address biases in Generally Accepted Accounting Principles (GAAP) that can obscure a company's true economic performance. The development of EVA laid the groundwork for the broader concept of "Adjusted Economic Premium," as it highlighted the necessity of tailoring financial metrics to reflect a company's unique economic circumstances and the true cost of capital. While not a single, universally standardized metric like accounting profit, the Adjusted Economic Premium builds upon the principles championed by EVA to offer a customized, more insightful measure of economic performance.

Key Takeaways

  • Adjusted Economic Premium measures the economic value a company creates, considering all costs, including the opportunity cost of capital.
  • It goes beyond traditional accounting profit by incorporating specific adjustments to financial data for a truer economic picture.
  • A positive Adjusted Economic Premium indicates that a company is generating returns exceeding the minimum required by its investors.
  • It serves as a powerful internal management tool for capital allocation and evaluating strategic initiatives.
  • The calculation involves careful consideration and often subjective adjustments to align with economic realities rather than just accounting conventions.

Formula and Calculation

The Adjusted Economic Premium calculation typically builds upon the foundational concept of economic profit or Economic Value Added (EVA). It aims to refine the Net Operating Profit After Tax (NOPAT) and the invested capital base to derive a more accurate measure of economic value creation.

The basic formula for an Adjusted Economic Premium can be expressed as:

Adjusted Economic Premium=Adjusted NOPAT−(Adjusted Invested Capital×Adjusted WACC)\text{Adjusted Economic Premium} = \text{Adjusted NOPAT} - (\text{Adjusted Invested Capital} \times \text{Adjusted WACC})

Where:

  • (\text{Adjusted NOPAT}) represents the Net Operating Profit After Tax, adjusted for certain non-cash items, expensed investments (like R&D or advertising), or other accounting distortions to better reflect true operating profitability.
  • (\text{Adjusted Invested Capital}) refers to the total capital employed by the business, adjusted to include items that accounting standards might expense but which are, in an economic sense, investments (e.g., goodwill, certain R&D outlays, operating leases capitalized). This provides a more accurate base against which to measure the return on invested capital.
  • (\text{Adjusted WACC}) (Weighted Average Cost of Capital) is the average rate of return a company expects to pay to its capital providers (debt and equity holders), potentially adjusted to reflect a more precise cost of capital based on risk or specific financing structures.

These adjustments seek to ensure that all economic resources consumed are accounted for, and that the calculation provides a clear signal of value creation.

Interpreting the Adjusted Economic Premium

Interpreting the Adjusted Economic Premium provides critical insights into a company's operational efficiency and strategic effectiveness. A positive Adjusted Economic Premium indicates that a company is creating wealth beyond the cost of the capital employed. In essence, the business is generating returns greater than its investors' required rate of return, signifying true shareholder value creation. This is a strong signal of sustainable performance and effective capital allocation.

Conversely, a negative Adjusted Economic Premium suggests that the company is destroying economic value. Even if a business reports a positive accounting profit, it might have a negative Adjusted Economic Premium if its returns do not cover the implicit cost of its capital. This indicates that the resources invested could potentially generate a higher return elsewhere, prompting management to reassess strategies, divest underperforming assets, or optimize its capital structure. The metric's primary utility lies in its ability to highlight whether a business is merely profitable on paper or genuinely creating economic wealth for its owners.

Hypothetical Example

Consider "Alpha Innovations Inc.," a technology firm that reported a revenue of $20 million last year.

  • Its explicit operating costs (salaries, rent, materials, etc.) were $12 million.
  • Its reported Net Operating Profit After Tax (NOPAT) was $5 million.
  • The total invested capital, as per its balance sheet, was $30 million.
  • The company's Weighted Average Cost of Capital (WACC) is 10%.

However, Alpha Innovations' management wants to calculate its Adjusted Economic Premium, recognizing that standard accounting might not fully capture its economic reality. They decide to make two key adjustments:

  1. Adjusting NOPAT: Alpha Innovations spent $1 million on a major brand-building advertising campaign that was expensed immediately according to accounting rules but is considered a long-term investment by management. They decide to add this back to NOPAT for economic premium calculation purposes, spreading its economic impact over several years.
    • Adjusted NOPAT = $5 million (original NOPAT) + $1 million (reclassified advertising expense) = $6 million.
  2. Adjusting Invested Capital: The company also has $2 million in off-balance sheet operating leases that, from an economic standpoint, represent invested capital.
    • Adjusted Invested Capital = $30 million (original capital) + $2 million (capitalized leases) = $32 million.
  3. Adjusted WACC: For specific internal analysis, they've determined a slightly higher risk-adjusted return of 11% is more appropriate for projects of this nature.

Now, calculate the Adjusted Economic Premium:

Adjusted Economic Premium=Adjusted NOPAT−(Adjusted Invested Capital×Adjusted WACC)\text{Adjusted Economic Premium} = \text{Adjusted NOPAT} - (\text{Adjusted Invested Capital} \times \text{Adjusted WACC}) Adjusted Economic Premium=$6,000,000−($32,000,000×0.11)\text{Adjusted Economic Premium} = \$6,000,000 - (\$32,000,000 \times 0.11) Adjusted Economic Premium=$6,000,000−$3,520,000\text{Adjusted Economic Premium} = \$6,000,000 - \$3,520,000 Adjusted Economic Premium=$2,480,000\text{Adjusted Economic Premium} = \$2,480,000

In this hypothetical example, Alpha Innovations Inc. generated an Adjusted Economic Premium of $2.48 million. This positive figure indicates that even after accounting for the reclassified investment in branding and capitalized leases, and using a higher adjusted cost of capital, the company is still creating significant economic value.

Practical Applications

The Adjusted Economic Premium is a powerful tool for strategic decision-making and performance evaluation within an organization. Companies employ this metric to gain a clearer understanding of their true value creation, often using it in several key areas:

  • Performance Evaluation: It helps evaluate the performance of business units, projects, or even individual managers by linking their activities directly to wealth creation rather than just reported profits. This encourages managers to consider the full cost of capital and resources used.
    *7 Strategic Planning: By revealing which segments or strategies truly add value, the Adjusted Economic Premium guides strategic planning. Businesses can allocate resources more effectively to initiatives that promise a higher Adjusted Economic Premium, fostering long-term growth and valuation.
  • Capital Budgeting: When evaluating potential investments or projects, the Adjusted Economic Premium provides a robust framework. Projects with a positive Adjusted Economic Premium are those expected to generate returns above the required cost of capital, making them desirable. This aligns closely with net present value principles.
  • Compensation and Incentives: Linking executive and employee compensation to the Adjusted Economic Premium can better align management's interests with those of shareholders. This incentivizes decisions that maximize economic value rather than short-term accounting gains.
  • Mergers & Acquisitions Analysis: In evaluating potential acquisition targets, the Adjusted Economic Premium can help determine if the target company, once integrated, is likely to generate economic value for the acquiring firm. It provides a more comprehensive view than traditional profitability metrics alone.

By focusing on this metric, companies can optimize their capital allocation and cultivate a culture of value creation.

Limitations and Criticisms

While the Adjusted Economic Premium offers a more economically sound view of profitability, it is not without limitations and criticisms. One significant challenge lies in the subjectivity involved in making the necessary adjustments to financial statements. Identifying and accurately quantifying "economic" adjustments, such as capitalizing R&D expenses or revaluing assets, can be complex and may vary between different analysts or organizations. This subjectivity can lead to inconsistencies and make cross-company comparisons challenging.,
6
5Furthermore, the calculation of the Adjusted Economic Premium relies heavily on estimates, particularly for the cost of capital and various implicit costs. Changes in market conditions or assumptions can significantly impact the calculated premium, leading to volatility. C4ritics also point out that while conceptually superior, the Adjusted Economic Premium, and similar economic profit metrics, can be more complex to calculate and communicate to stakeholders who are more accustomed to the simpler, widely understood accounting profit. This can create communication challenges and resistance to adoption. Despite its theoretical advantages, practical implementation can be difficult, especially for large companies with complex financial structures.

3## Adjusted Economic Premium vs. Economic Value Added (EVA)

The terms "Adjusted Economic Premium" and "Economic Value Added (EVA)" are closely related, with the former often building upon the principles and methodologies of the latter. Economic Value Added (EVA) is a specific, trademarked financial performance metric popularized by Stern Stewart & Co. It is defined as a company's Net Operating Profit After Tax (NOPAT) minus its capital charge (invested capital multiplied by the Weighted Average Cost of Capital). A key aspect of EVA is the series of "adjustments" made to NOPAT and invested capital to convert accounting figures into more economically accurate amounts.

Adjusted Economic Premium can be considered a broader, more flexible concept that encompasses the core idea of EVA. While EVA follows a prescribed set of accounting adjustments advocated by Stern Stewart, "Adjusted Economic Premium" implies a tailored approach where a company might apply its own specific adjustments based on its industry, strategic priorities, or unique economic circumstances. For example, one company's "Adjusted Economic Premium" might include a specific adjustment for human capital development or proprietary technology, which might not be standard in a typical EVA calculation. The confusion between the two often arises because both aim to provide a truer measure of economic profitability by factoring in the cost of capital and making adjustments to reported figures. However, EVA is a brand-specific methodology, whereas Adjusted Economic Premium is a descriptive term for any economic profit metric that incorporates specific, customized adjustments.

FAQs

Why is Adjusted Economic Premium different from accounting profit?

Adjusted Economic Premium differs from accounting profit primarily because it includes both explicit (out-of-pocket) and implicit (opportunity) costs, especially the cost of capital. Accounting profit, which is reported on financial statements, only subtracts explicit costs from revenue. The Adjusted Economic Premium also incorporates further specific adjustments to conventional accounting figures to better reflect economic realities, providing a more complete picture of actual value creation.

2### Who typically uses Adjusted Economic Premium?

Adjusted Economic Premium is primarily used by corporate management, financial analysts, and consultants for internal performance measurement, strategic planning, and capital allocation decisions. It helps them understand whether the business is truly generating value above its cost of capital.

Can Adjusted Economic Premium be negative?

Yes, the Adjusted Economic Premium can be negative. A negative value indicates that the company is not generating enough profit to cover its total cost of capital, including the implicit opportunity cost. Even if a company has a positive accounting profit, it can still have a negative Adjusted Economic Premium if its capital could be earning a higher return in an alternative investment.

1### How does Adjusted Economic Premium help in decision-making?

It aids decision-making by providing a clear signal of whether a particular investment, project, or business unit is truly creating economic value. By focusing on the Adjusted Economic Premium, managers are incentivized to make choices that maximize long-term shareholder value and ensure efficient use of capital, rather than just optimizing reported short-term accounting numbers. It promotes a focus on risk-adjusted return.