What Is Adjusted Economic Profit?
Adjusted Economic Profit is a financial performance metric that measures a company's true profitability by accounting for the cost of all capital employed, including both debt and equity, and by making various adjustments to reported accounting profit. Unlike traditional accounting profit, which primarily considers explicit costs, Adjusted Economic Profit aims to capture the full economic cost of doing business, including the opportunity cost of capital. This approach falls under the broader category of Financial Performance Metrics and provides a more holistic view of value creation for shareholders. The concept is closely related to Economic Value Added (EVA), often serving as a refined version tailored to a specific company's operations or analytical needs. By focusing on the residual income after all capital has been compensated, Adjusted Economic Profit helps assess whether a company is truly generating wealth above its required rate of return.
History and Origin
The concept of economic profit, which underpins Adjusted Economic Profit, has roots in classical economic theory, distinguishing between accounting costs and the broader notion of economic costs, including implicit costs. However, the modern popularization of a structured economic profit measure, often termed Economic Value Added (EVA), is largely attributed to the consulting firm Stern Stewart & Co. in the early 1990s.8 They developed and copyrighted EVA as a management tool designed to align managerial decisions with the goal of maximizing shareholder value.7 While the core idea of subtracting a capital charge from profit was not entirely new, Stern Stewart's methodology formalized the adjustments necessary to convert accounting figures into a true economic profit, promoting its adoption among large corporations.6
Key Takeaways
- Adjusted Economic Profit measures a company's profitability after deducting the full cost of capital, including the opportunity cost of equity.
- It provides a more accurate picture of value creation compared to traditional accounting profit by considering all resources employed.
- The calculation involves various adjustments to reported earnings to reflect a truer economic reality.
- It is often used as a key performance measurement tool to incentivize management and guide capital allocation decisions.
- A positive Adjusted Economic Profit indicates that a company is generating returns exceeding its cost of capital, thus creating value.
Formula and Calculation
The calculation of Adjusted Economic Profit typically begins with a company's Net Operating Profit After Tax (NOPAT) and subtracts a capital charge. The "adjusted" aspect refers to specific modifications made to NOPAT or invested capital to better reflect economic realities, such as treating certain operating leases as capitalized assets or adjusting for non-cash items.
The general formula is:
Where:
- (\text{Adjusted NOPAT}) represents the net operating profit after tax, adjusted for specific non-cash items, operating lease expenses, research and development, or other items to more accurately reflect cash flows from operations.
- (\text{Adjusted Invested Capital}) is the total capital employed by the business, adjusted for items such as accumulated goodwill amortization, asset revaluations, or deferred tax liabilities to represent a more accurate picture of the economic capital base.
- (\text{Weighted Average Cost of Capital}) (WACC) is the average rate of return a company expects to pay to its investors (debt and equity holders) to finance its assets. It represents the minimum return on investment a company must earn to satisfy its investors.
The capital charge, (\text{Adjusted Invested Capital} \times \text{Weighted Average Cost of Capital}), represents the dollar amount of return required by providers of capital for the risk they have undertaken.5
Interpreting the Adjusted Economic Profit
Interpreting Adjusted Economic Profit centers on whether a company is creating or destroying value. A positive Adjusted Economic Profit indicates that the company's operating profit, after all economic adjustments, exceeds the cost of the capital employed. This signifies value creation, meaning the company is generating returns above what investors demand. Conversely, a negative Adjusted Economic Profit suggests value destruction, implying that the company's returns are not sufficient to cover its full cost of capital.
Analysts use this metric to evaluate management effectiveness, particularly in terms of how efficiently capital is being utilized. Comparing a company's Adjusted Economic Profit over several periods can reveal trends in its ability to generate sustainable returns. It helps stakeholders understand if the company's projects and operations are truly profitable from an economic perspective, going beyond the often narrower view provided by traditional financial ratios derived solely from the income statement.
Hypothetical Example
Consider "Alpha Manufacturing Inc." which has a reported NOPAT of $20 million. After an in-depth analysis, an analyst makes the following adjustments:
- Add back $2 million in expensed research and development costs, considering them as investments contributing to future value.
- Adjust invested capital for $5 million in off-balance sheet operating leases, treating them as financed assets.
Original Invested Capital: $150 million
Weighted Average Cost of Capital (WACC): 10%
Step 1: Calculate Adjusted NOPAT
Adjusted NOPAT = Reported NOPAT + R&D Adjustment
Adjusted NOPAT = $20 million + $2 million = $22 million
Step 2: Calculate Adjusted Invested Capital
Adjusted Invested Capital = Original Invested Capital + Operating Lease Adjustment
Adjusted Invested Capital = $150 million + $5 million = $155 million
Step 3: Calculate the Capital Charge
Capital Charge = Adjusted Invested Capital × WACC
Capital Charge = $155 million × 0.10 = $15.5 million
Step 4: Calculate Adjusted Economic Profit
Adjusted Economic Profit = Adjusted NOPAT - Capital Charge
Adjusted Economic Profit = $22 million - $15.5 million = $6.5 million
Alpha Manufacturing Inc. has an Adjusted Economic Profit of $6.5 million. This positive figure indicates that Alpha Manufacturing is creating value for its shareholders, as its adjusted operating profit exceeds the cost of all capital it employs.
Practical Applications
Adjusted Economic Profit finds significant application in corporate finance and investment analysis, particularly for internal management and strategic decision-making. Companies often use it as a performance metric for various business units, fostering a focus on efficient capital utilization. For instance, a large financial institution like BBVA uses economic profit and risk-adjusted return on capital (RAROC) as fundamental metrics for its value-based management system, making adjustments to net attributable profit for items like generic provisions and unrealized capital gains.
4Furthermore, it is employed in:
- Performance Evaluation: Tying management compensation directly to Adjusted Economic Profit can incentivize decisions that genuinely enhance shareholder wealth, as it encourages managers to consider the full cost of capital.
- Capital Budgeting: When evaluating new projects or investments, companies can forecast the Adjusted Economic Profit each venture is expected to generate, helping prioritize those that promise the highest value creation. This aids in robust risk management by ensuring projects clear a high economic hurdle.
- Mergers and Acquisitions (M&A): During due diligence, potential acquirers may calculate the Adjusted Economic Profit of a target company to gauge its true underlying profitability and assess its ability to generate returns above its cost of capital post-acquisition.
- Shareholder Communication: While not a GAAP or IFRS reported figure, presenting Adjusted Economic Profit can provide investors with a clearer understanding of how effectively the company is generating value from the resources entrusted to it.
Limitations and Criticisms
While Adjusted Economic Profit offers a comprehensive view of value creation, it is not without its limitations and criticisms. One primary challenge lies in the subjectivity inherent in the "adjustments" themselves. The specific adjustments made to NOPAT and invested capital can vary significantly between companies, industries, or even within the same company over time, making cross-company comparisons difficult without detailed disclosures of the adjustments. As a result, the calculation of Adjusted Economic Profit can be complex and requires detailed financial data, which might deter smaller organizations from using this metric.
3Furthermore, the determination of the Weighted Average Cost of Capital (WACC) involves estimations, such as the cost of equity, which can also introduce variability. If the assumptions underlying the WACC or the adjustments are flawed, the resulting Adjusted Economic Profit figure may not accurately reflect true economic performance. The concept, particularly in its EVA form, has also been viewed through the lens of a "management fashion," experiencing periods of rising and falling popularity rather than sustained universal adoption. T2his suggests that while conceptually sound, its practical implementation and consistent application face challenges, especially for companies with cyclical operating profits, significant intangible assets, or volatile capital expenditures.
1## Adjusted Economic Profit vs. Economic Profit
The terms Adjusted Economic Profit and Economic Profit are closely related, with the former typically representing a more refined or specific application of the latter. Economic Profit, in its fundamental definition, is the difference between total revenues and total economic costs, which include both explicit costs (like wages and raw materials) and implicit costs (such as the opportunity cost of capital). It's a broad economic concept that contrasts directly with accounting profit by incorporating the cost of foregone alternatives.
Adjusted Economic Profit takes this core concept and layers on specific, systematic modifications to a company's reported financial figures. These adjustments are typically made to align accounting statements more closely with economic realities, for instance, by capitalizing expenses traditionally treated as operating costs (like certain research and development outlays) or by reclassifying financial items. The purpose of these adjustments is to eliminate accounting distortions and provide a "cleaner" view of a firm's operating performance and capital base for internal analysis and external valuation. While all Adjusted Economic Profit is a form of Economic Profit, not all Economic Profit calculations involve the detailed, specific adjustments that characterize Adjusted Economic Profit.
FAQs
Why is Adjusted Economic Profit considered a better measure of profitability than accounting profit?
Adjusted Economic Profit is often considered superior because it accounts for the full cost of capital, including the opportunity cost of equity. Accounting profit, while useful for statutory reporting, does not typically include this implicit cost, making it appear as if a company is profitable even if it isn't generating a return above what investors could earn elsewhere with similar risk. By recognizing all costs, Adjusted Economic Profit provides a more accurate picture of a company's true value creation.
Who uses Adjusted Economic Profit?
Primarily, large corporations and sophisticated investors use Adjusted Economic Profit. Companies often employ it internally for performance evaluation, strategic planning, capital allocation, and to align management incentives with shareholder wealth creation. Analysts and financial professionals may also use it to assess a company's fundamental economic performance.
Can a company have a positive accounting profit but a negative Adjusted Economic Profit?
Yes, this is entirely possible and highlights the key difference between the two metrics. A company might report a positive accounting profit because its revenues exceed its explicit costs. However, if that profit is not high enough to cover the implicit cost of the equity capital employed (the return shareholders could have earned on an alternative investment of similar risk), then its Adjusted Economic Profit would be negative, indicating that it is not truly creating value for its shareholders.
What kinds of adjustments are typically made in Adjusted Economic Profit?
Adjustments can vary, but common ones include:
- Capitalizing research and development expenses or marketing costs that are deemed to have long-term benefits.
- Treating operating leases as debt and the leased assets as part of invested capital.
- Adjusting for non-cash items or certain provisions that distort true operating cash flow.
- Revaluing assets to their current market value rather than historical cost.
The goal is to move from an accounting-based view to an economic-based view of a company's financial health and performance measurement.