Adjusted economic profit exposure

What Is Adjusted Economic Profit Exposure?

Adjusted Economic Profit Exposure is a concept within corporate finance that refines the understanding of a company's true profitability by factoring in the cost of all capital, including equity, and adjusting for various accounting distortions. It belongs to the broader category of performance measurement frameworks, aiming to provide a more accurate assessment of value creation than traditional accounting profit measures. While standard accounting profit focuses solely on explicit costs, Adjusted Economic Profit Exposure considers implicit costs, such as the opportunity cost of capital, which represents the return shareholders could have earned on an alternative investment of similar risk³⁷. This metric offers insights into whether a business is generating returns above and beyond what is required to compensate all providers of capital³⁶.

History and Origin

The concept of economic profit, distinct from accounting profit, has roots in classical economic theory, where economists recognized that profit should account for the return on all resources, including the owner's capital and time³⁵. The formalization of adjusting accounting profit to arrive at a more "economic" view of performance gained prominence with the rise of value-based management systems in the late 20th century. Companies and financial institutions began to seek metrics that better aligned internal decision-making with shareholder wealth creation.

One notable application of these adjusted profit metrics can be seen in the financial reporting of large institutions. For instance, BBVA, a global financial services group, has explicitly used economic profit and risk-adjusted return on capital (RAROC) as fundamental metrics in its value-based management system since the early 2000s. Their approach involves making specific adjustments to net attributable profit, such as accounting for expected losses and changes in unrealized capital gains, to derive a more accurate picture of economic performance³³, ³⁴. This shift reflects a broader industry movement towards sophisticated financial modeling that incorporates a holistic view of capital costs and risk.

Key Takeaways

• Adjusted Economic Profit Exposure provides a comprehensive measure of a company's true profitability by including both explicit and implicit costs, particularly the cost of equity capital.
• It helps assess whether a business is creating value beyond the minimum required return for all resources employed.
• Unlike accounting profit, which is primarily for external reporting, Adjusted Economic Profit Exposure is often used for internal decision-making, capital allocation, and performance evaluation.
• Calculating this metric involves adjusting reported net profit for various accounting conventions and factoring in the charge for using capital.
• A positive Adjusted Economic Profit Exposure suggests that the company is generating returns exceeding its cost of capital, indicating value creation.

Formula and Calculation

The calculation of Adjusted Economic Profit Exposure typically begins with a company's net operating profit after tax (NOPAT) and then subtracts a capital charge. The capital charge represents the cost of using both debt and equity capital.

The general formula for Economic Profit (EP), which forms the basis for Adjusted Economic Profit Exposure, is:

Where:

• ( NOPAT ) = Net Operating Profit After Tax. This is the profit a company makes from its core operations after deducting taxes, but before accounting for interest expenses.
• ( Invested\ Capital ) = The total capital employed by the business, including both debt and equity. It represents the total funds invested in the operations of the company.
• ( WACC ) = Weighted Average Cost of Capital. This is the average rate of return a company expects to pay to all its capital providers, including both equity holders and debt holders. It is a critical component for understanding the true economic cost of funding a business³².

Adjusted Economic Profit Exposure further refines this by making specific adjustments to NOPAT and/or Invested Capital to remove accounting distortions and better reflect economic reality. These adjustments can include, but are not limited to, changes for:

• Research and development (R&D) expenses, often treated as investments rather than immediate expenses.
• Operating leases, which may be capitalized.
• Provisions and reserves, to reflect actual economic exposures rather than accounting estimates³¹.

Interpreting the Adjusted Economic Profit Exposure

Interpreting Adjusted Economic Profit Exposure provides a clear signal about a company's economic health and its ability to generate wealth. A positive Adjusted Economic Profit Exposure indicates that the company is earning more than the required return on all the capital invested in the business, signifying true value creation³⁰. Conversely, a negative Adjusted Economic Profit Exposure means the company is not covering its full cost of capital, effectively destroying shareholder value even if it reports an accounting profit²⁸, ²⁹.

This metric helps management evaluate the efficiency of their resource allocation and operational strategies. It encourages a focus on maximizing value creation rather than just maximizing reported earnings, which can sometimes be influenced by accounting policies. For investors, a consistently positive Adjusted Economic Profit Exposure suggests a strong, sustainable business model with a potential competitive advantage.

Hypothetical Example

Consider "InnovateTech Inc.," a software development company. In a given year, InnovateTech reports a Net Operating Profit After Tax (NOPAT) of $10 million. The company has invested capital of $50 million, and its Weighted Average Cost of Capital (WACC) is 12%.

First, calculate the capital charge:
Capital Charge = Invested Capital × WACC
Capital Charge = $50,000,000 × 0.12 = $6,000,000

Next, calculate the basic economic profit:
Economic Profit = NOPAT - Capital Charge
Economic Profit = $10,000,000 - $6,000,000 = $4,000,000

Now, let's consider an adjustment. Suppose InnovateTech expensed $2 million in R&D that, from an economic perspective, should be treated as an investment with a useful life, as it contributes to future revenue streams. To calculate the Adjusted Economic Profit Exposure, we would add back a portion of this R&D expense. For simplicity, let's assume a full add-back for this year for the purpose of demonstrating the adjustment, meaning the economically adjusted NOPAT is higher.

Adjusted NOPAT = Original NOPAT + R&D Adjustment
Adjusted NOPAT = $10,000,000 + $2,000,000 = $12,000,000

Now, the Adjusted Economic Profit Exposure:
Adjusted Economic Profit Exposure = Adjusted NOPAT - Capital Charge
Adjusted Economic Profit Exposure = $12,000,000 - $6,000,000 = $6,000,000

In this hypothetical example, by adjusting for the R&D expenditure, InnovateTech's Adjusted Economic Profit Exposure is $6 million, indicating a stronger value creation than initially suggested by the unadjusted economic profit. This highlights the importance of making such adjustments to get a clearer picture of business valuation.

Practical Applications

Adjusted Economic Profit Exposure is a versatile metric used across various facets of finance and business.

• Corporate Performance Management: It serves as a core metric in corporate performance management systems, allowing companies to evaluate the true profitability of business units, projects, and even individual initiatives. By focusing on economic profit, companies can ensure that capital is deployed in areas that generate returns above the cost of capital, aligning with shareholder interests.
  ²⁷* Capital Allocation: This metric is crucial for effective capital allocation. Projects or investments with positive expected Adjusted Economic Profit Exposure are prioritized, as they are anticipated to create value. Conversely, those with negative expected economic profit are re-evaluated or rejected, preventing value destruction.
  ²⁶* Mergers and Acquisitions (M&A): During M&A activities, Adjusted Economic Profit Exposure can be used to assess the target company's standalone value creation and the potential for synergy-driven value enhancement post-acquisition. This helps in making informed investment decisions.
• Executive Compensation: Tying executive compensation to Adjusted Economic Profit Exposure incentivizes management to make decisions that enhance long-term shareholder value rather than focusing solely on short-term accounting profits.
• Risk Management: While Adjusted Economic Profit Exposure itself isn't a direct measure of risk, its use in conjunction with risk-adjusted return on capital (RAROC) frameworks allows financial institutions to understand the profitability of activities relative to the economic capital consumed by risk. For example, BBVA uses economic profit and RAROC to manage its value creation and assess the risk-adjusted return of its business units. ²⁴, ²⁵This approach helps in building a more resilient financial strategy.

Limitations and Criticisms

While Adjusted Economic Profit Exposure offers a robust view of profitability, it is not without limitations and criticisms.

One primary challenge lies in the difficulty of accurate estimation, particularly concerning implicit costs like opportunity cost. ²³Assigning a precise value to what a company "gave up" by choosing one path over another can be subjective and difficult to quantify reliably. This can lead to variations in calculation and interpretation across different analysts or organizations.
²²
Furthermore, the process of making accounting adjustments can introduce complexity and potential for manipulation. Deciding which accounting conventions to adjust and how to value invested capital (e.g., historical cost versus replacement value) requires careful judgment and can significantly impact the resulting figure. ²¹Critics argue that if not carefully addressed, these measurement challenges can lead to inconsistencies.
²⁰
Another point of contention is that Adjusted Economic Profit Exposure, while comprehensive, does not account for all important financial aspects or non-financial factors that may influence a company's long-term success. ¹⁹For example, strong brand equity, customer loyalty, or a highly innovative culture—factors not directly captured in the formula—can significantly contribute to future value creation. Some argue that an overreliance on this metric might neglect these qualitative aspects. Moreover, changes in external factors like interest rates or a company's credit rating can impact the cost of capital, and thus the Adjusted Economic Profit Exposure, even if the underlying operational efficiency remains unchanged.

Aca¹⁸demic discussions and real-world observations sometimes highlight a common misunderstanding: economic theory suggests that in perfectly competitive markets, economic profit tends towards zero in the long run. This¹⁷ does not imply that businesses in competitive markets are always on the brink of bankruptcy, but rather that they earn a "normal profit," which covers all explicit and implicit costs, including a fair return on capital. However, businesses can achieve positive economic profit by possessing competitive advantages or operating in less competitive environments. Ther¹⁵, ¹⁶efore, understanding the market structure and a firm's specific advantages is crucial when interpreting this metric.

Adjusted Economic Profit Exposure vs. Economic Exposure

While both terms contain "economic" and "exposure," Adjusted Economic Profit Exposure and Economic Exposure measure distinct aspects of a company's financial performance and risk.

Adjusted Economic Profit Exposure is a tool for internal financial analysis to gauge a company's true value creation. In contrast, Economic Exposure is a risk management concept dealing specifically with the impact of foreign exchange rate movements on a firm's long-term competitiveness and profitability.

⁵FAQs

What is the primary difference between Adjusted Economic Profit Exposure and accounting profit?

The primary difference is that Adjusted Economic Profit Exposure includes both explicit (cash) costs and implicit (opportunity) costs, such as the cost of equity capital, while accounting profit only considers explicit costs. This makes Adjusted Economic Profit Exposure a more comprehensive measure of true economic value creation.

Why is it important to adjust economic profit?

Adjusting economic profit helps to remove distortions caused by traditional accounting conventions, providing a clearer picture of a company's underlying economic performance. This allows for better financial decision-making, more effective capital allocation, and a more accurate assessment of whether a business is truly creating or destroying value for its shareholders.

###³, ⁴ Can a company have a positive accounting profit but negative Adjusted Economic Profit Exposure?
Yes, this is possible. A co¹, ²mpany might report a positive accounting profit because its revenues exceed its explicit costs. However, if the return on its invested capital is less than the opportunity cost of that capital, or if significant accounting adjustments reveal a less favorable economic reality, its Adjusted Economic Profit Exposure could be negative. This indicates that the company is not earning enough to cover the full economic cost of all its resources.

How does Adjusted Economic Profit Exposure relate to shareholder value?

Adjusted Economic Profit Exposure is directly linked to shareholder value. When a company consistently generates positive Adjusted Economic Profit Exposure, it means it is creating value in excess of the capital employed, which typically translates to increased shareholder wealth. Conversely, negative Adjusted Economic Profit Exposure implies value destruction.

Is Adjusted Economic Profit Exposure a widely reported metric?

No, Adjusted Economic Profit Exposure is not typically a publicly reported metric like accounting profit. It is primarily an internal management tool used for strategic planning, performance evaluation, and capital budgeting. Companies that use value-based management systems might internally track and report it to their executives and boards.