Adjusted economic profit effect

Adjusted Economic Profit Effect: Definition, Formula, Example, and FAQs

The Adjusted Economic Profit Effect refers to the change in a company's economic profit after making specific accounting adjustments to its reported financial statements. This concept falls under the broader category of corporate finance, specifically in the realm of valuation and performance measurement. The goal of these adjustments is to provide a more accurate representation of a firm's true economic performance by accounting for factors that traditional accounting metrics might overlook or misrepresent. By considering implicit costs and normalizing various accounting treatments, the Adjusted Economic Profit Effect offers a clearer picture of whether a company is truly creating value above and beyond its cost of capital.

History and Origin

The foundational concept of economic profit, which accounts for both explicit and implicit costs, has roots in classical economic theory. However, its popularization as a practical performance metric, particularly with a focus on specific adjustments, largely emerged with the development and promotion of Economic Value Added (EVA) by the consulting firm Stern Stewart & Co. in the early 1990s³⁸, ³⁹, ⁴⁰. Joel Stern and Bennett Stewart were key figures in evangelizing this measure, emphasizing its ability to better capture a firm's true economic profit and link it directly to shareholder wealth creation³⁵, ³⁶, ³⁷.

Stern Stewart identified numerous potential accounting adjustments (reportedly over 160) to align reported financial figures more closely with economic realities³³, ³⁴. These adjustments often involved converting accounting measures of earnings and capital to reflect a more realistic surplus value. For instance, converting operating leases into financial expenses or adjusting for goodwill were among the types of modifications suggested³². This rigorous approach to refining reported profits and capital aimed to provide a more transparent view of a company's actual value generation, going beyond the limitations of standard Generally Accepted Accounting Principles (GAAP).

Key Takeaways

• The Adjusted Economic Profit Effect measures the change in economic profit after specific accounting modifications.
• It aims to provide a more accurate view of a company's true economic performance and value creation.
• Adjustments often correct for accounting treatments that may obscure economic realities.
• A positive Adjusted Economic Profit Effect indicates that a company is generating returns exceeding its total costs, including opportunity costs.
• This metric helps in evaluating the efficiency of resource allocation and strategic decision-making.

Formula and Calculation

The calculation of economic profit itself is the difference between a company's Net Operating Profit After Tax (NOPAT) and its capital charge. The "Adjusted Economic Profit Effect" comes into play when NOPAT or capital employed (or both) are modified.

The general formula for Economic Profit is:

Where:

• (\text{NOPAT}) = Net Operating Profit After Tax
• (\text{Invested Capital}) = Total capital invested in the business
• (\text{WACC}) = Weighted Average Cost of Capital

For the Adjusted Economic Profit Effect, various adjustments are made to NOPAT and/or Invested Capital. These adjustments can include:

• Capitalization of R&D expenses: Instead of expensing them, treating research and development (R&D) as a capital investment and amortizing it over its useful life³¹.
• Adjusting for operating leases: Reclassifying operating leases as financial leases and including the leased assets and corresponding debt on the balance sheet³⁰.
• Goodwill adjustments: Accounting for both recorded and unrecorded goodwill²⁹.
• Non-cash restructuring and asset impairment costs: Adding these back to earnings and adjusting capital employed to reflect cash earnings and total capital investment²⁸.
• Provisions and unrealized gains/losses: Adjusting for generic provisions or unrealized capital gains/losses in certain portfolios²⁷.

The "Effect" then refers to the change in the overall economic profit metric that results from applying these specific adjustments.

Interpreting the Adjusted Economic Profit Effect

Interpreting the Adjusted Economic Profit Effect involves understanding how the various accounting adjustments influence the final economic profit figure. A positive adjusted economic profit suggests that the company is generating a return that exceeds its true cost of capital, including the opportunity cost of all capital employed. This signifies that the business is creating economic value and is efficiently utilizing its resources. Conversely, a negative adjusted economic profit indicates that the company is not earning enough to cover its total cost of capital, implying that its resources could be better deployed elsewhere.

The magnitude of the Adjusted Economic Profit Effect, both positive and negative, provides insight into the extent of value creation or destruction. A large positive effect implies significant value generation, while a large negative effect points to substantial value erosion. Analysts use this metric to assess a company's long-term viability and to determine whether management decisions are genuinely enhancing shareholder value. It offers a more holistic view than traditional accounting profit, as it accounts for capital usage efficiency²⁶.

Hypothetical Example

Consider "AlphaTech Inc.," a software development company. In a given year, AlphaTech reports a Net Operating Profit After Tax (NOPAT) of $10 million. Its invested capital is $80 million, and its Weighted Average Cost of Capital (WACC) is 10%.

Initial Economic Profit calculation:
Economic Profit = $10,000,000 - ($80,000,000 * 0.10)
Economic Profit = $10,000,000 - $8,000,000
Economic Profit = $2,000,000

Now, let's consider an adjustment. AlphaTech expensed $5 million in R&D, but for economic profit analysis, this should be capitalized and amortized over five years. This means we add back the $5 million to NOPAT and add it to invested capital. Assuming a full year's R&D spend and ignoring amortization for simplicity in this initial adjustment:

Adjusted NOPAT = $10,000,000 + $5,000,000 = $15,000,000
Adjusted Invested Capital = $80,000,000 + $5,000,000 = $85,000,000

Adjusted Economic Profit calculation:
Adjusted Economic Profit = $15,000,000 - ($85,000,000 * 0.10)
Adjusted Economic Profit = $15,000,000 - $8,500,000
Adjusted Economic Profit = $6,500,000

In this hypothetical example, the Adjusted Economic Profit Effect is an increase from $2,000,000 to $6,500,000, or a $4,500,000 positive effect. This adjustment reveals that AlphaTech's true economic value creation is significantly higher than initially perceived, due to the value generated by its R&D investments, which are more accurately reflected as capital expenditures rather than immediate expenses. This revised view helps evaluate the company's long-term strategic investments.

Practical Applications

The Adjusted Economic Profit Effect finds significant practical applications in various areas of finance and business management. It is primarily used by companies and investors seeking a more comprehensive understanding of true profitability and value creation.

• Performance Measurement and Incentives: Many companies, particularly large corporations, integrate adjusted economic profit measures into their internal performance management systems. By linking management compensation to adjusted economic profit, firms can encourage decision-making that focuses on long-term value creation rather than just short-term accounting profits²⁵. This helps align the interests of managers with those of shareholders.
• Capital Allocation Decisions: Businesses leverage adjusted economic profit to evaluate the true financial impact of potential investment opportunities and projects²³, ²⁴. It provides a more robust framework for comparing different ventures by factoring in the opportunity cost of capital, leading to more efficient capital allocation²². For instance, the energy sector, with its significant capital infrastructure, uses economic profit to evaluate projects based on both immediate and long-term returns²¹.
• Mergers and Acquisitions (M&A): In mergers and acquisitions (M&A), the Adjusted Economic Profit Effect can provide a more accurate assessment of a target company's true value. By making necessary adjustments to its financial statements, acquirers can better gauge the economic viability of the acquisition and the potential for synergy²⁰.
• Investor Analysis: Investors and analysts utilize adjusted economic profit to assess a company's ability to generate returns above its cost of capital. Companies consistently reporting positive adjusted economic profit are often viewed favorably, as it indicates effective management and sustainable long-term growth potential¹⁸, ¹⁹. Researchers also analyze the impact of factors like monetary information shocks on a firm's economic profit to distinguish between value-creating and value-destroying firms¹⁷.

Limitations and Criticisms

While the Adjusted Economic Profit Effect offers a more comprehensive view of a company's financial performance, it is not without limitations and criticisms. One primary concern revolves around the subjectivity involved in making the necessary accounting adjustments. Determining which adjustments to make and the specific methodologies for these adjustments can be complex and may vary across analysts or firms. Stern Stewart, for instance, identified a vast number of potential adjustments, which can make the calculation intricate and potentially prone to manipulation or inconsistency¹⁵, ¹⁶.

Critics also argue that despite the adjustments, economic profit measures might still be influenced by short-term considerations, particularly in industries requiring significant long-term investments where positive cash flows may only materialize in the distant future¹⁴. Furthermore, the complexity of identifying and quantifying implicit costs, such as the true opportunity cost of capital, can be challenging, especially for smaller businesses¹³.

Some academic research suggests that while economic value-added measures have merits, they may not always provide a universally superior measure of firm performance when compared to traditional accounting metrics. Some studies indicate that conventional net income or operating income may still hold significant informational value, even when adjusted economic profit is in use¹⁰, ¹¹, ¹². Moreover, the validity of economic profit metrics in unstable or emerging markets, where economic conditions and interest rates can be volatile, has also been debated, with some studies suggesting the need for further formula modifications in such environments⁹.

Adjusted Economic Profit Effect vs. Economic Value Added (EVA)

The terms "Adjusted Economic Profit Effect" and "Economic Value Added (EVA)" are closely related, with EVA being a specific, trademarked variant of economic profit developed by Stern Stewart & Co. The Adjusted Economic Profit Effect refers to the impact of specific accounting modifications on a company's economic profit. EVA, on the other hand, is an economic profit metric that incorporates a defined set of these adjustments.

In essence, EVA is a highly structured application of the principle behind the Adjusted Economic Profit Effect, aiming to provide a standardized way to measure true economic profitability by making specific adjustments to financial statements.

FAQs

What is the primary purpose of calculating the Adjusted Economic Profit Effect?

The primary purpose is to gain a more accurate and comprehensive understanding of a company's true profitability and its ability to create economic value, beyond what traditional accounting profit measures might show. It helps in assessing whether a company is generating returns that exceed its total cost of capital, including implicit costs.

How does the Adjusted Economic Profit Effect differ from traditional accounting profit?

Traditional accounting profit primarily considers explicit costs (e.g., wages, rent, materials). The Adjusted Economic Profit Effect, conversely, incorporates both explicit and implicit costs, especially the opportunity cost of capital, and makes specific accounting adjustments to provide a truer picture of economic performance and efficient capital utilization⁴, ⁵.

Are the adjustments made for the Adjusted Economic Profit Effect standardized?

No, the adjustments are not fully standardized. While methodologies like Economic Value Added (EVA) propose specific adjustments, the choice and implementation of adjustments can vary depending on the analyst's or company's approach. This subjectivity is one of the criticisms of the concept³.

Can a company have a positive accounting profit but a negative Adjusted Economic Profit Effect?

Yes, a company can have a positive accounting profit but a negative Adjusted Economic Profit Effect. This occurs if the company's accounting profit is not high enough to cover its total cost of capital, including the opportunity cost of funds and other implicit costs that are factored into the adjusted economic profit calculation². This indicates that while the business is profitable on paper, it may not be generating enough value to justify the capital invested, implying that resources could be better used elsewhere.

Is the Adjusted Economic Profit Effect useful for all types of businesses?

The Adjusted Economic Profit Effect is particularly useful for businesses with significant capital investments and those focused on long-term value creation. While beneficial for large corporations and publicly traded companies, smaller businesses might find it more challenging to identify and estimate the necessary implicit costs, making accounting profit a more straightforward metric for them¹.