What Is Adjusted Economic Profit Margin?
Adjusted Economic Profit Margin is a financial metric that evaluates a company's profitability by considering not only explicit accounting costs but also the opportunity cost of the capital employed. Unlike traditional accounting measures that only subtract explicit costs from revenue, this margin incorporates implicit costs, providing a more comprehensive view of true value creation. It falls under the broader umbrella of corporate finance and is designed to indicate how efficiently a business is generating profit above its total cost of capital. By focusing on the economic profit relative to a base like revenue, the Adjusted Economic Profit Margin helps assess how well a company is performing beyond merely covering its operational expenses.
History and Origin
The concept of economic profit has roots in classical economics, with early economists like Alfred Marshall discussing profits that go beyond covering the normal costs of production. Marshall, a dominant figure in British economics, contributed significantly to microeconomic theory, including concepts related to profit and the supply-demand equilibrium.9 His work laid some foundational ideas about the returns necessary to sustain a business.8
The more formalized concept of "economic profit" as it relates to business performance measurement evolved significantly in the latter half of the 20th century. A key development was the popularization of Economic Value Added (EVA) by the consulting firm Stern Stewart & Co. in the early 1980s.7 Co-founded by Joel Stern and Bennett Stewart, the firm championed EVA as a superior measure of corporate performance, emphasizing that companies should earn a return above their true cost of capital to create shareholder value.6 Stern Stewart's methodology involved making various adjustments to conventional accounting figures to better reflect economic reality, leading to metrics like the Adjusted Economic Profit Margin, which seeks to quantify this economic surplus as a proportion of a company's sales or capital base. This approach aimed to align management decisions with value creation for owners.5
Key Takeaways
- Adjusted Economic Profit Margin measures a company's true profitability by including both explicit and implicit costs, notably the cost of capital.
- It provides a more accurate picture of wealth creation than traditional accounting profit.
- A positive Adjusted Economic Profit Margin indicates that a company is generating returns that exceed the cost of all resources used, including equity.
- This metric is a valuable tool for internal performance assessment and for external analysts evaluating a firm's efficiency and value generation.
- Calculations often involve adjustments to standard accounting figures to align them with economic principles.
Formula and Calculation
The Adjusted Economic Profit Margin is derived from the concept of economic profit, often in the context of methodologies like Economic Value Added (EVA). While EVA represents the absolute dollar amount of economic profit, the margin expresses this profit as a percentage, typically of revenue or capital.
A common approach to calculate the underlying economic profit involves adjusting the company's operating profit and then subtracting a capital charge. The "adjusted" aspect refers to modifications made to conventional accounting numbers to better reflect economic reality.
The formula for the Adjusted Economic Profit Margin can be expressed as:
Where:
- Adjusted NOPAT represents Net Operating Profit After Tax (NOPAT)) after making various economic adjustments (e.g., capitalizing research and development, adjusting for operating leases).
- Capital Employed is the total capital invested in the business, adjusted to reflect the true economic investment.4
- Cost of Capital is the weighted average cost of all financing sources (debt and equity).3
- Revenue is the total sales generated by the company.
Interpreting the Adjusted Economic Profit Margin
Interpreting the Adjusted Economic Profit Margin involves assessing whether a company is truly creating value. A positive Adjusted Economic Profit Margin signifies that the company's adjusted net operating profit after tax exceeds the total cost of the capital it employs. This indicates that the business is not only covering its operational expenses and debt costs but also generating a return above what investors could earn elsewhere for a similar level of risk, thereby creating economic value.
Conversely, a negative Adjusted Economic Profit Margin suggests that the company is not earning enough to cover its total cost of capital. In such a scenario, the business is effectively destroying economic value, even if it reports a positive accounting profit. A zero margin implies the company is generating just enough profit to cover its cost of capital, earning a "normal profit" in economic terms. This metric is a strong indicator of management effectiveness in utilizing capital and can be a critical component of performance evaluation. It directly links to the concept of return on capital, but with a more rigorous deduction for the cost of financing.
Hypothetical Example
Consider "InnovateTech Solutions," a hypothetical software company.
- Adjusted NOPAT: $12 million
- Capital Employed: $80 million
- Cost of Capital: 10%
- Revenue: $100 million
First, calculate the capital charge:
Capital Charge = Capital Employed × Cost of Capital
Capital Charge = $80,000,000 × 0.10 = $8,000,000
Next, calculate the Adjusted Economic Profit:
Adjusted Economic Profit = Adjusted NOPAT - Capital Charge
Adjusted Economic Profit = $12,000,000 - $8,000,000 = $4,000,000
Finally, calculate the Adjusted Economic Profit Margin:
Adjusted Economic Profit Margin = (Adjusted Economic Profit / Revenue) × 100%
Adjusted Economic Profit Margin = ($4,000,000 / $100,000,000) × 100% = 4%
In this example, InnovateTech Solutions has an Adjusted Economic Profit Margin of 4%. This indicates that for every dollar of revenue generated, the company produces 4 cents of economic profit after accounting for both operational expenses and the full cost of capital.
Practical Applications
The Adjusted Economic Profit Margin is a powerful analytical tool with several practical applications across various financial disciplines. In investment analysis, it provides a more robust indicator of a company's true performance compared to traditional accounting metrics. Analysts can use this margin to gauge how effectively a company is creating value for its shareholders, beyond merely reporting positive earnings.
For strategic planning within corporations, the Adjusted Economic Profit Margin can guide capital allocation decisions. Business units or projects with higher Adjusted Economic Profit Margins demonstrate greater efficiency in using capital and creating value, helping management prioritize investments. This metric is also integrated into corporate governance frameworks, often serving as a basis for executive compensation to align management incentives with long-term value creation.
Furthermore, it can be employed in valuation models, providing a forward-looking perspective on a company's ability to generate sustainable economic returns. The CFA Institute, for example, has discussed the evolution and "best-practice" applications of EVA, highlighting its role in enhancing investment decision-making by addressing shortcomings of accounting-based metrics.
##2 Limitations and Criticisms
While the Adjusted Economic Profit Margin offers a sophisticated view of profitability, it is not without limitations. A primary criticism lies in the complexity and subjectivity involved in making the "adjustments" to standard accounting figures. These adjustments, which aim to convert conventional financial statements into a more economically accurate representation, can vary significantly depending on the firm applying the methodology. This variability can lead to inconsistencies in comparisons between companies or even within the same company over different periods if the adjustment methodologies change.
Estimating the true cost of capital can also be challenging, as it involves assumptions about market risk premiums and a company's capital structure. Furthermore, like any single financial metric, the Adjusted Economic Profit Margin should not be viewed in isolation. It may not fully capture qualitative factors such as brand strength, customer loyalty, innovation potential, or effective risk management strategies, which are crucial for long-term success. Some academic perspectives also view the popularization of metrics like EVA (a form of adjusted economic profit) as part of management fashion, suggesting their rise and fall in popularity might be influenced by trends rather than solely by inherent analytical superiority.
##1 Adjusted Economic Profit Margin vs. Economic Profit
The distinction between Adjusted Economic Profit Margin and Economic profit lies primarily in their form and what they convey. Economic profit (or Adjusted Economic Profit) is an absolute dollar amount that represents the surplus value a company generates after covering all its costs, including the implicit cost of capital. It answers the question: "How many dollars of economic value did the company create?"
In contrast, the Adjusted Economic Profit Margin expresses this economic surplus as a ratio or percentage, typically by dividing the Adjusted Economic Profit by a base figure like revenue or capital employed. It answers the question: "How efficiently is the company creating economic value relative to its size or sales?" While economic profit indicates the total magnitude of value created or destroyed, the margin provides a normalized measure of efficiency. This allows for easier comparison of performance across companies of different sizes or over different time periods, without the scale of operations distorting the assessment. Both metrics are valuable but serve different analytical purposes.
FAQs
What is the primary difference between Adjusted Economic Profit Margin and traditional accounting profit?
The primary difference is that Adjusted Economic Profit Margin accounts for both explicit costs (like wages and materials) and implicit costs, particularly the opportunity cost of capital. Traditional accounting profit only considers explicit costs. This means the Adjusted Economic Profit Margin provides a more comprehensive view of a company's true profitability and value creation.
Why is including the cost of capital important for this metric?
Including the cost of capital is crucial because capital, whether debt or equity, is a resource with an associated cost. By subtracting this cost, the Adjusted Economic Profit Margin determines if a company is generating returns above the minimum required by investors. If a company's profit doesn't cover its cost of capital, it's not truly creating economic value, even if it's profitable from an accounting perspective.
How does a positive Adjusted Economic Profit Margin benefit a company?
A positive Adjusted Economic Profit Margin indicates that a company is generating wealth for its shareholders above and beyond the cost of all resources used. This can lead to increased investor confidence, higher stock prices, and improved access to capital for future growth. It also suggests efficient resource utilization and strong management.
Can Adjusted Economic Profit Margin be used for company valuation?
Yes, Adjusted Economic Profit Margin and its underlying concept, economic profit, are closely linked to valuation methodologies like discounted cash flow. The present value of a company's projected Adjusted Economic Profits over time can be used as a robust measure of its intrinsic value, as it directly quantifies the economic value expected to be created. This approach helps in understanding whether a company's current market value reflects its economic reality.