Adjusted economic profit index

What Is Adjusted Economic Profit Index?

The Adjusted Economic Profit Index is a sophisticated performance measurement metric used primarily within the framework of Value-Based Management. It refines the traditional concept of Economic Profit by incorporating various adjustments to provide a more accurate and comprehensive view of a company's true financial performance and value creation. Unlike simple accounting profit, which only considers explicit costs, economic profit accounts for both explicit and opportunity cost of capital, representing the true cost of all resources used. The "Adjusted" aspect means that specific, often firm-specific, modifications are made to the components of economic profit to better reflect economic realities and align with strategic objectives, while "Index" signifies its role as a key indicator for evaluating and comparing value generation.

History and Origin

The concept of economic profit, which underpins the Adjusted Economic Profit Index, has roots dating back to the late 19th century with Alfred Marshall's view of profit as residual income for a firm's owner after accounting for capital and business effort.¹⁴ However, the modern emphasis on "economic profit" as a central metric for corporate performance gained significant traction with the rise of Value-Based Management (VBM) in the late 20th century.¹¹, ¹², ¹³

Pioneers in VBM, such as Alfred Rappaport with his focus on shareholder value and consultants like Stern Stewart & Co. with their Economic Value Added (EVA™) framework, popularized the idea that a company truly creates value only when its return on capital exceeds its cost of capital. O⁹, ¹⁰ver time, as businesses became more complex and financial reporting faced scrutiny, the need for more nuanced measures arose. The "Adjusted" aspect of economic profit evolved from the recognition that standard accounting figures often do not fully capture economic realities, requiring adjustments for items like off-balance sheet financing, non-cash expenses, or specific risk exposures to paint a clearer picture of actual value creation.

Key Takeaways

• The Adjusted Economic Profit Index refines traditional economic profit by incorporating specific adjustments for a more precise view of value creation.
• It is a core metric within Value-Based Management, aiming to measure true economic value generated.
• Adjustments can include reclassifying certain expenses, accounting for off-balance sheet items, or incorporating risk-related considerations.
• A positive Adjusted Economic Profit Index indicates that a company is generating returns above its true cost of capital and creating shareholder value.
• It serves as an internal benchmark or performance measurement tool to guide capital allocation and strategic decisions.

Formula and Calculation

The Adjusted Economic Profit Index is derived from the fundamental economic profit formula, which is typically calculated as:

Where:

• Net Operating Profit After Tax (NOPAT): The company's operating income adjusted for taxes, excluding the impact of financing costs.
  *⁸ Invested Capital: The total capital employed by the business, including both debt and equity.
• Weighted Average Cost of Capital (WACC): The average rate of return a company expects to pay to its investors to finance its assets, considering the proportion of debt and equity in its capital structure.

⁷To arrive at the Adjusted Economic Profit Index, the base economic profit formula undergoes specific modifications. These adjustments aim to convert accounting numbers into economic realities. Common adjustments include:

1. Reclassification of Operating Leases: Treating operating leases as debt to reflect the true capital employed.
2. Capitalization of R&D/Marketing Expenses: Recognizing these as investments that generate future benefits, rather than immediate expenses, and amortizing them over their useful life.
3. Adjustments for Non-Cash Charges: Adding back certain non-cash expenses, such as depreciation and amortization, to align with a cash-flow perspective more closely.
4. Provisions and Reserves: Adjusting for generic provisions or specific reserves to reflect actual expected losses more accurately.
   5⁶. Unrealized Gains/Losses: Incorporating or removing unrealized gains or losses from holding portfolios to focus on recurrent, core profitability.
   6⁵. Economic Risk Capital: Incorporating concepts like Economic Risk Capital (ERC) into the capital charge to better reflect the risk profile of the business units.

⁴The resulting figure, the Adjusted Economic Profit, acts as the "Index," indicating the actual value created above and beyond all capital costs, including the inherent opportunity cost of deploying capital.

Interpreting the Adjusted Economic Profit Index

Interpreting the Adjusted Economic Profit Index involves assessing whether a company is truly adding economic value. A positive Adjusted Economic Profit Index indicates that the company's operations are generating returns higher than the minimum required by its capital providers, including both equity and debt holders, after considering all economic costs and making specific accounting adjustments. This signifies successful shareholder value creation.

Conversely, a negative Adjusted Economic Profit Index suggests that the company is destroying economic value, as its returns are not covering its full cost of capital. While a company might report a positive accounting profit, a negative Adjusted Economic Profit Index would reveal that it is not earning enough to compensate its investors for the risk and capital they provide. This metric provides a crucial lens for management to evaluate the effectiveness of its capital allocation decisions and overall business strategy.

Hypothetical Example

Consider "InnovateTech Inc.," a software company, that is evaluating its financial performance using the Adjusted Economic Profit Index for the fiscal year.

Initial Data:

• Net Operating Profit After Tax (NOPAT): $50 million
• Invested Capital (from balance sheet): $400 million
• Weighted Average Cost of Capital (WACC): 10%

Standard Economic Profit Calculation:
Economic Profit = $50 million - ($400 million × 0.10) = $50 million - $40 million = $10 million

Now, InnovateTech Inc. makes the following adjustments to arrive at its Adjusted Economic Profit Index:

1. Capitalization of Software Development Costs: The company spent $15 million on software development, which was expensed immediately in accounting profit. For economic profit, they decide to capitalize and amortize it over 3 years, adding $10 million (2/3 of $15M) back to NOPAT for this year after current year's amortization is considered.
2. Off-Balance Sheet Operating Leases: InnovateTech has operating leases with a present value of $20 million, which are not on the balance sheet. This capital needs to be added to Invested Capital.

Adjusted Calculation:

• Adjusted NOPAT = $50 million (original NOPAT) + $10 million (capitalized development cost adjustment) = $60 million
• Adjusted Invested Capital = $400 million (original Invested Capital) + $20 million (operating lease capitalization) = $420 million

Adjusted Economic Profit Index Calculation:
Adjusted Economic Profit = $60 million - ($420 million × 0.10) = $60 million - $42 million = $18 million

In this example, InnovateTech's Adjusted Economic Profit Index is $18 million. This positive figure indicates that even after accounting for investments typically expensed and off-balance sheet financing, the company is still generating $18 million in value above its true cost of all capital employed. This refined metric provides a more accurate picture for strategic management decisions.

Practical Applications

The Adjusted Economic Profit Index serves as a powerful tool in various facets of corporate finance and performance measurement.

1. Strategic Decision-Making: It helps guide significant corporate decisions such as mergers and acquisitions, divestitures, and major capital expenditures. By providing a more accurate view of true profitability, the Adjusted Economic Profit Index enables management to prioritize initiatives that genuinely create shareholder value.
2. Performance Evaluation and Compensation: Many companies integrate Adjusted Economic Profit into their internal performance evaluation systems for business units and management teams. Tying compensation to this metric encourages managers to make decisions that consider the true cost of capital and generate economic returns.
3. Capital Allocation: It provides a robust framework for capital allocation across different projects and divisions. Resources can be directed towards areas that generate the highest Adjusted Economic Profit, thereby optimizing overall corporate value.
4. Valuation and Investor Relations: While not always publicly disclosed, the underlying principles of Adjusted Economic Profit are vital for internal valuation models and for communicating a company's value creation story to investors. A focus on economic profit highlights a commitment to long-term value generation rather than short-term accounting profits.
5. Corporate Governance: Enhanced corporate governance frameworks, such as the OECD Principles of Corporate Governance, emphasize transparency and accountability in financial performance. The³ use of an Adjusted Economic Profit Index aligns with these principles by providing a more comprehensive and economically sound measure of performance, fostering greater trust among stakeholders.

Limitations and Criticisms

While the Adjusted Economic Profit Index offers a more robust measure of value creation than traditional accounting profits, it is not without limitations or criticisms. One primary challenge lies in the subjectivity inherent in making the "adjustments." The specific adjustments chosen and their methodology can vary significantly between companies or even within the same company over time, making comparability difficult. This lack of standardization can lead to questions about the consistency and objectivity of the reported index.

Another criticism revolves around the complexity of its calculation. Deriving accurate Weighted Average Cost of Capital and making numerous reclassifications and estimations for invested capital and Net Operating Profit After Tax can be data-intensive and require significant judgment. Errors in these estimations can lead to a misleading Adjusted Economic Profit Index. Implementing and sustaining such a detailed performance measurement system can also be challenging for organizations, requiring substantial resources and commitment.

Fu²rthermore, critics argue that excessive focus on any single metric, including an Adjusted Economic Profit Index, can lead to short-termism or neglect of qualitative factors crucial for long-term success, such as innovation, customer satisfaction, or employee morale. Some studies suggest that while Value-Based Management principles are sound, their implementation often falls short, with programs focusing too much on measurement and too little on the actual management activities that create shareholder value. The¹ metric is also backward-looking and may not fully capture future growth opportunities or strategic shifts.

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

The Adjusted Economic Profit Index and Economic Value Added (EVA) are closely related concepts within the realm of Value-Based Management, both aiming to measure a company's true economic profit rather than just accounting profit. The fundamental goal of both metrics is to quantify the value a company creates above its cost of capital.

The key distinction lies in their specificity and application. EVA, a trademarked term developed by Stern Stewart & Co., typically involves a standardized set of adjustments to accounting data to arrive at its NOPAT and invested capital figures. While EVA itself is a form of economic profit with specific adjustments, the "Adjusted Economic Profit Index" implies a broader, possibly more customized approach to economic profit calculation. It suggests that a company or analyst may apply a unique set of granular adjustments beyond the standard EVA framework, tailored to their specific industry, operational nuances, or strategic objectives. Therefore, while all EVAs are economic profits, an Adjusted Economic Profit Index can be a proprietary or more extensively modified version of economic profit that includes a wider or different array of adjustments than typically seen in a standard EVA calculation.

FAQs

What does "Adjusted" mean in this context?

"Adjusted" refers to the process of modifying a company's reported financial figures (like revenues, expenses, and capital) to better reflect economic reality rather than just accounting conventions. These adjustments are made to account for items such as non-cash charges, off-balance sheet financing, or reclassification of certain investments, providing a clearer picture of value creation.

Why is an "Index" used in the name?

The term "Index" in Adjusted Economic Profit Index indicates that it functions as a critical indicator or measure of a company's ability to generate economic value. It signifies a refined metric used for assessing financial performance, comparing results over time, or benchmarking against competitors, similar to how other financial indices track performance.

How does it differ from traditional accounting profit?

Traditional accounting profit (like net income) only considers explicit costs and follows accounting standards, which may not fully capture the economic cost of capital or the true impact of certain investments. The Adjusted Economic Profit Index goes further by deducting the implicit cost of capital and making various adjustments to reflect a company's actual economic performance and its ability to create shareholder value.

Is the Adjusted Economic Profit Index publicly reported?

Generally, no. The Adjusted Economic Profit Index is primarily an internal performance measurement and management tool. Companies typically do not disclose this specific calculation in their public financial statements, although they may report standard accounting profits and other key performance indicators derived from their financial data.

Who uses the Adjusted Economic Profit Index?

It is primarily used by corporate executives, financial analysts, and consultants involved in strategic management, capital allocation, and performance evaluation within organizations that emphasize a Value-Based Management philosophy.