Adjusted economic profit indicator

What Is Adjusted Economic Profit Indicator?

The Adjusted Economic Profit Indicator is a sophisticated financial metric that measures a company's true profitability by considering not only its explicit accounting costs but also the implicit costs, most notably the opportunity cost of the capital employed. It belongs to the broader category of financial analysis and aims to provide a more comprehensive view of value creation than traditional accounting profit measures. Essentially, the Adjusted Economic Profit Indicator reveals whether a business is generating a return that exceeds the minimum required return on the capital invested by its providers. A positive Adjusted Economic Profit Indicator suggests that the company is creating wealth for its shareholders after accounting for all costs, both explicit and implicit.

History and Origin

The foundational concept of economic profit, which accounts for both explicit and implicit costs, has roots in classical economic theory, emphasizing the idea that profit should exceed the return that could have been earned from alternative uses of capital. The distinction between accounting and economic profit has been discussed by economists for centuries.¹⁰

The modern application and popularization of a specific framework for measuring economic profit in a corporate setting largely trace back to the introduction of Economic Value Added (EVA) by Stern Stewart & Co. (now Stern Value Management) in the late 1980s and early 1990s. This proprietary metric aimed to quantify the "true economic profit" by adjusting traditional accounting figures to reflect economic realities more accurately, thereby creating a measure similar to the Adjusted Economic Profit Indicator. The goal was to align managerial decisions with the creation of shareholder wealth.

Key Takeaways

• The Adjusted Economic Profit Indicator goes beyond traditional accounting profit by including the cost of capital, both debt and equity.
• It provides a more accurate assessment of a company's true value creation and economic efficiency.
• A positive Adjusted Economic Profit Indicator indicates that a company is generating returns above its cost of capital, thereby adding value.
• The metric encourages managers to make decisions that optimize resource allocation and enhance long-term financial performance.
• Calculating the Adjusted Economic Profit Indicator often involves making several adjustments to standard financial statements to better reflect economic realities.

Formula and Calculation

The Adjusted Economic Profit Indicator, often represented by metrics like Economic Value Added (EVA), is generally calculated as:

Where:

• NOPAT (Net Operating Profit After Tax): This represents the company's operating profit after taxes but before financing costs. It aims to capture the profits generated from core operations available to all capital providers. It can be derived from the company's income statement.
• Invested Capital: This is the total capital employed by the business to generate its operating profit. It often includes both debt and shareholders' equity. Adjustments may be made to figures from the balance sheet to better reflect the true economic capital.
• WACC (Weighted Average Cost of Capital): This is the average rate of return a company expects to pay its investors, reflecting the blended cost of its various sources of capital, including debt and equity. It represents the minimum rate of return required to satisfy all capital providers. The WACC is a crucial component of a company's capital structure.

The term ( (\text{Invested Capital} \times \text{WACC}) ) is often referred to as the "capital charge," representing the cost of using the capital.

Interpreting the Adjusted Economic Profit Indicator

Interpreting the Adjusted Economic Profit Indicator involves assessing whether a company is truly creating value.

• Positive Adjusted Economic Profit Indicator: A positive value signifies that the company's operating profit, after taxes, exceeds the cost of the capital employed. This indicates that the business is generating returns greater than the minimum required by its investors, effectively creating wealth. Such a result suggests efficient resource allocation and strong management performance.
• Zero Adjusted Economic Profit Indicator: A zero value means the company's NOPAT exactly covers its cost of capital. While it implies that the company is covering all its economic costs, it is not generating additional wealth beyond the opportunity cost of the capital.
• Negative Adjusted Economic Profit Indicator: A negative value suggests that the company's NOPAT is less than its cost of capital. This indicates that the business is not generating sufficient returns to cover the economic cost of the capital it employs, effectively destroying wealth. Such a situation may prompt a re-evaluation of business strategies or investment analysis.

The Adjusted Economic Profit Indicator helps stakeholders gauge how effectively a business maximizes its resources and aligns decisions with long-term strategic planning.

Hypothetical Example

Consider "Tech Innovate Inc.," a software development company. For the past year, Tech Innovate Inc. reported:

• Revenue: $1,500,000
• Operating Expenses (excluding interest and taxes): $800,000
• Taxes: $200,000
• Invested Capital: $3,000,000
• Weighted Average Cost of Capital (WACC): 10%

First, calculate NOPAT:
Operating Profit = Revenue - Operating Expenses = $1,500,000 - $800,000 = $700,000
NOPAT = Operating Profit - Taxes = $700,000 - $200,000 = $500,000

Next, calculate the Capital Charge:
Capital Charge = Invested Capital × WACC = $3,000,000 × 0.10 = $300,000

Finally, calculate the Adjusted Economic Profit Indicator:
Adjusted Economic Profit Indicator = NOPAT - Capital Charge = $500,000 - $300,000 = $200,000

In this hypothetical example, Tech Innovate Inc. has an Adjusted Economic Profit Indicator of $200,000. This positive value suggests that the company generated $200,000 in wealth above and beyond the cost of its capital, indicating strong financial performance and efficient use of its investments. This insight is particularly valuable for evaluating capital expenditure decisions.

Practical Applications

The Adjusted Economic Profit Indicator is a versatile tool used across various financial disciplines to enhance decision-making and measure value creation.

• Corporate Performance Measurement: Companies use it to evaluate the true profitability of their operations, business units, or specific projects. It incentivizes managers to focus on returns that exceed the cost of capital, thus promoting value-adding activities. For instance, companies in capital-intensive sectors like energy often use economic profit to assess the viability of major infrastructure projects, considering both immediate and long-term returns.
  *⁹ Investment Analysis and Valuation: Investors and analysts utilize the Adjusted Economic Profit Indicator to determine whether a company is truly creating wealth for its shareholders. A consistent positive indicator can signal a healthy, well-managed business. This metric provides a deeper insight than traditional profitability ratios by incorporating the cost of capital into the analysis.
• Executive Compensation and Incentives: Linking executive bonuses and compensation to the Adjusted Economic Profit Indicator can align management interests directly with shareholder wealth creation. This encourages executives to make decisions that not only generate accounting profits but also produce returns above the cost of capital. Such value-based management approaches are detailed in frameworks used by consulting firms. PwC White Paper
• Capital Budgeting: When evaluating potential investment projects, businesses can use the Adjusted Economic Profit Indicator to compare different opportunities. It helps in selecting projects that are expected to generate returns significantly higher than their respective costs of capital, leading to more efficient resource allocation.

Limitations and Criticisms

While a powerful tool, the Adjusted Economic Profit Indicator has several limitations and criticisms that warrant consideration:

• Accounting Adjustments: The calculation relies heavily on various accounting adjustments to Net Operating Profit After Tax (NOPAT) and invested capital. These adjustments, which can number over a hundred in theory, introduce subjectivity and complexity. D⁷, ⁸ifferent accounting methods (e.g., depreciation, inventory valuation) can significantly affect the calculation, potentially distorting the true economic reality of the company.
  *⁶ Cost of Capital Estimation: Accurately determining the Weighted Average Cost of Capital (WACC) can be challenging. It requires precise estimation of the cost of equity, which often involves subjective inputs like beta or market risk premium, and the cost of debt. Incorrect WACC calculations can lead to flawed Adjusted Economic Profit Indicator results and, consequently, poor decision-making.
  *⁵ Short-Term Focus: Despite aiming for a long-term view, the Adjusted Economic Profit Indicator is typically calculated using annual data, which can sometimes emphasize short-term performance. This might disincentivize long-term investments like research and development if their immediate impact on the indicator is negative, even if they promise substantial future returns.
  *³, ⁴ Intangible Assets: The metric, particularly when based on traditional accounting balance sheets, may not fully capture the value of intangible assets such as brand recognition, intellectual property, or human capital. These assets are crucial drivers of modern businesses but are often understated or excluded from the invested capital base, potentially misrepresenting the true economic profit generated.
  *² Applicability Across Industries: The effectiveness of the Adjusted Economic Profit Indicator can vary across different industries. It is often considered most suitable for asset-heavy companies where invested capital is easily identifiable and measurable. For service-oriented or technology companies with substantial intangible assets, its application might be less straightforward.

¹These limitations necessitate careful judgment and supplementary analysis when using the Adjusted Economic Profit Indicator for decision-making. Sabinet African Journals (PDF)

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

The terms "Adjusted Economic Profit Indicator" and "Economic Value Added (EVA)" are often used interchangeably in practice because EVA is a prominent and widely recognized proprietary measure that embodies the concept of adjusted economic profit. Both metrics aim to quantify the true economic profit generated by a company by deducting a capital charge from the after-tax operating profit.

The primary distinction, when one exists, is often in the specific methodologies and proprietary adjustments applied. EVA, as popularized by Stern Stewart & Co., involves a detailed set of accounting adjustments to financial statements to more accurately reflect economic reality, such as capitalizing certain expenses or adjusting for deferred taxes. While the general concept of an Adjusted Economic Profit Indicator follows the same principle (NOPAT minus a capital charge), the term "Adjusted Economic Profit Indicator" can be a broader, generic descriptor for any metric that adjusts traditional accounting profit to include the cost of capital and other economic considerations. Therefore, EVA can be considered a specific, widely-used implementation of an Adjusted Economic Profit Indicator.

FAQs

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

The fundamental difference lies in the inclusion of implicit costs. Accounting profit only considers explicit costs (e.g., wages, rent, materials) and is the figure reported on a company's income statement. The Adjusted Economic Profit Indicator, however, also factors in implicit costs, primarily the opportunity cost of the capital invested. This means it accounts for the return that could have been earned if the capital had been invested in the next best alternative.

Why is the Adjusted Economic Profit Indicator important for investors?

For investors, the Adjusted Economic Profit Indicator provides a more holistic view of a company's performance by indicating whether the company is truly creating wealth beyond merely covering its explicit costs. A consistently positive Adjusted Economic Profit Indicator suggests that management is efficiently utilizing capital and generating returns that exceed the cost of financing, which is a strong signal for long-term value creation and can be vital for effective investment analysis.

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

Yes, this is entirely possible and highlights the importance of the Adjusted Economic Profit Indicator. A company might report a positive accounting profit but still have a negative Adjusted Economic Profit Indicator if the profits generated are not sufficient to cover the company's full cost of capital (both debt and equity). In such a scenario, the business is not creating economic value, implying that its resources could be better deployed elsewhere.

How does the Weighted Average Cost of Capital (WACC) relate to the Adjusted Economic Profit Indicator?

The Weighted Average Cost of Capital (WACC) is a crucial component of the Adjusted Economic Profit Indicator formula. It represents the minimum rate of return a company must earn on its existing asset base to satisfy its lenders and shareholders. The Adjusted Economic Profit Indicator essentially measures whether the company's after-tax operating profit exceeds this capital charge, making WACC the benchmark for value creation.

Is the Adjusted Economic Profit Indicator applicable to all types of businesses?

While conceptually applicable to all businesses, the practical calculation and interpretation of the Adjusted Economic Profit Indicator can be more challenging for certain types of companies. It is often more straightforward for asset-heavy businesses with clearly identifiable invested capital. For companies with significant intangible assets (e.g., software firms, consulting services), measuring the "invested capital" accurately for the Adjusted Economic Profit Indicator calculation can be complex, as many value-generating assets may not appear on the balance sheet in their full economic value.