Skip to main content
diversification.com
← Back to A Definitions

Adjusted economic profit yield

What Is Adjusted Economic Profit Yield?

Adjusted Economic Profit Yield is a financial metric used within the field of Corporate Valuation that measures the true economic profitability of a business relative to the capital employed to generate that profit. Unlike accounting profit, which only considers explicit costs, Adjusted Economic Profit Yield incorporates both explicit and implicit costs, including the opportunity cost of capital. This broader perspective provides a more comprehensive view of how efficiently a company is utilizing its resources and creating shareholder value. A positive Adjusted Economic Profit Yield indicates that a company is generating returns exceeding the minimum required by its investors, considering the alternative uses of their capital.

History and Origin

The concept of economic profit, upon which Adjusted Economic Profit Yield is based, has roots in classical economics, distinguishing between accounting measures and the true cost of resources, including implicit costs. However, its popularization in modern corporate finance largely stems from the development of "Economic Value Added" (EVA) in the 1980s by Stern Stewart & Co. EVA, which is a specific type of economic profit calculation, became widely adopted in the U.S. and globally in the early to mid-1990s as a performance measurement approach aimed at aligning managerial decisions with shareholder wealth creation.11 The underlying principle—that value is created only when returns exceed the cost of all capital, including equity—is central to both EVA and Adjusted Economic Profit Yield, aiming to bridge the gap between financial reporting and economic reality.

Key Takeaways

  • Adjusted Economic Profit Yield considers both explicit and implicit costs, including the opportunity cost of capital, offering a holistic view of profitability.
  • It serves as a more accurate indicator of a company's true value creation compared to traditional accounting measures.
  • A positive Adjusted Economic Profit Yield suggests efficient resource allocation and that the company is generating returns above its cost of capital.
  • It is a crucial metric for investors and managers assessing a firm's long-term sustainability and ability to generate wealth.

Formula and Calculation

Adjusted Economic Profit Yield is typically derived from the economic profit of a company, expressed as a yield or percentage of the capital base. The core concept revolves around Net Operating Profit After Tax (NOPAT) less a capital charge.

The formula for Economic Profit (EP) is:

EP=NOPAT−(InvestedCapital×WACC)EP = NOPAT - (Invested Capital \times WACC)

Where:

  • NOPAT (Net Operating Profit After Tax): The company’s potential cash earnings if its capitalization were unlevered (debt-free). It is calculated as operating income (EBIT) multiplied by (1 - tax rate). This figure is a critical component, as it represents the profits generated by the company's core operations before considering how those operations are financed.
  • 10Invested Capital: The total capital deployed by the business, including both debt and equity. It represents the total amount of money invested in the company's assets.
  • 9WACC (Weighted Average Cost of Capital): The average rate a company expects to pay to finance its assets, considering the proportionate weights of all sources of capital (debt and equity).

The Adjusted Economic Profit Yield can then be expressed as:

Adjusted Economic Profit Yield=EPInvested Capital=NOPAT−(Invested Capital×WACC)Invested CapitalAdjusted \ Economic \ Profit \ Yield = \frac{EP}{Invested \ Capital} = \frac{NOPAT - (Invested \ Capital \times WACC)}{Invested \ Capital}

This can also be simplified to:

Adjusted Economic Profit Yield=(NOPATInvested Capital)−WACCAdjusted \ Economic \ Profit \ Yield = \left(\frac{NOPAT}{Invested \ Capital}\right) - WACC

Or, using Return on Invested Capital (ROIC), where (ROIC = \frac{NOPAT}{Invested \ Capital}):

Adjusted Economic Profit Yield=ROIC−WACCAdjusted \ Economic \ Profit \ Yield = ROIC - WACC

This formulation highlights that a company creates value when its ROIC exceeds its WACC.

I8nterpreting the Adjusted Economic Profit Yield

Interpreting Adjusted Economic Profit Yield involves assessing whether a company is generating returns that sufficiently compensate its capital providers, beyond what could be earned in an alternative investment of similar risk. A positive Adjusted Economic Profit Yield signifies that the company is creating wealth for its shareholders because its operating returns exceed its cost of capital. This indicates efficient deployment of invested capital and effective management that is truly adding economic value.

Conversely, a negative Adjusted Economic Profit Yield means the company is not generating enough profit to cover its total cost of capital, implying that capital could be better utilized elsewhere. Even if a company shows a positive accounting profit on its financial statements, a negative Adjusted Economic Profit Yield suggests it is destroying value from an economic perspective. This metric is thus invaluable for gauging true economic performance and resource allocation efficiency.

Hypothetical Example

Consider "InnovateTech Inc.", a technology company looking to evaluate its economic performance.

  • NOPAT (Net Operating Profit After Tax): $12,000,000
  • Invested Capital: $100,000,000
  • Weighted Average Cost of Capital (WACC): 10%

First, calculate the economic profit:

EP=NOPAT−(Invested Capital×WACC)EP=$12,000,000−($100,000,000×0.10)EP=$12,000,000−$10,000,000EP=$2,000,000EP = NOPAT - (Invested \ Capital \times WACC) \\ EP = \$12,000,000 - (\$100,000,000 \times 0.10) \\ EP = \$12,000,000 - \$10,000,000 \\ EP = \$2,000,000

Next, calculate the Adjusted Economic Profit Yield:

Adjusted Economic Profit Yield=EPInvested CapitalAdjusted Economic Profit Yield=$2,000,000$100,000,000Adjusted Economic Profit Yield=0.02 or 2%Adjusted \ Economic \ Profit \ Yield = \frac{EP}{Invested \ Capital} \\ Adjusted \ Economic \ Profit \ Yield = \frac{\$2,000,000}{\$100,000,000} \\ Adjusted \ Economic \ Profit \ Yield = 0.02 \text{ or } 2\%

Alternatively, using the ROIC method:

ROIC=NOPATInvested Capital=$12,000,000$100,000,000=0.12 or 12%ROIC = \frac{NOPAT}{Invested \ Capital} = \frac{\$12,000,000}{\$100,000,000} = 0.12 \text{ or } 12\% Adjusted Economic Profit Yield=ROIC−WACCAdjusted Economic Profit Yield=12%−10%Adjusted Economic Profit Yield=2%Adjusted \ Economic \ Profit \ Yield = ROIC - WACC \\ Adjusted \ Economic \ Profit \ Yield = 12\% - 10\% \\ Adjusted \ Economic \ Profit \ Yield = 2\%

In this scenario, InnovateTech Inc. has a positive Adjusted Economic Profit Yield of 2%. This indicates that the company is generating a return of 12% on its invested capital, which is 2 percentage points higher than the 10% minimum return required by its capital providers. This signals that InnovateTech is effectively creating shareholder value.

Practical Applications

Adjusted Economic Profit Yield is a versatile metric with several practical applications in finance and business management:

  • Performance Measurement: It offers a robust measure of a company's financial performance, specifically its efficiency in resource allocation. Unlike basic profit figures, it highlights whether a business is truly adding value above its full cost of capital.
  • Investment Analysis: Investors use Adjusted Economic Profit Yield to identify companies that are genuinely creating wealth for shareholders. A consistent positive yield suggests a sustainable competitive advantage and attractive investment potential. This aligns with the principle that companies create value when cash flows exceed their cost, including the opportunity cost of capital.
  • 7Strategic Decision-Making: Management can use this metric to evaluate various business opportunities, capital expenditure projects, and strategic initiatives. By focusing on initiatives that are expected to generate a positive Adjusted Economic Profit Yield, companies can ensure their growth aligns with value creation.
  • Executive Compensation: Linking executive incentives to Adjusted Economic Profit Yield can encourage managers to make decisions that maximize long-term shareholder wealth, rather than short-term accounting profits.
  • Corporate Restructuring and Mergers & Acquisitions: In corporate valuation, Adjusted Economic Profit Yield can assess the potential for value creation in mergers, acquisitions, or divestitures, by evaluating the economic return generated by the combined or divested assets.
  • Economic Trends Analysis: Aggregated corporate profit data, which forms the basis for economic profit calculations, is often analyzed by economic institutions. For instance, the Federal Reserve Board publishes data and analyses on corporate profits and margins, providing insights into broader economic trends and the financial health of the corporate sector.

L6imitations and Criticisms

Despite its advantages, Adjusted Economic Profit Yield, like its progenitor economic profit and related concepts like EVA, has several limitations and criticisms:

  • Sensitivity to Accounting Assumptions: The calculation relies heavily on accounting data, which can be influenced by various accounting policies and assumptions, such as depreciation methods, inventory valuation, and the treatment of goodwill. Different choices in these areas can lead to varying Adjusted Economic Profit Yield figures, making comparisons across companies challenging.
  • 5Difficulty in Estimating Implicit Costs: Accurately quantifying implicit costs, particularly the opportunity cost of equity capital, can be subjective and difficult. While the Weighted Average Cost of Capital (WACC) attempts to capture this, its calculation involves estimates and assumptions about market risk premiums, beta, and the company's capital structure.
  • 4Short-Term Focus: Some critics argue that focusing solely on a single period's Adjusted Economic Profit Yield can lead to a short-term managerial perspective, potentially discouraging long-term investments that may not yield immediate economic profit but are crucial for future growth and competitive advantage.
  • 3Exclusion of Intangible Assets: Traditional accounting often struggles to capture the value of intangible assets like brand reputation, intellectual property, or human capital. Since Adjusted Economic Profit Yield is tied to reported invested capital (often based on tangible assets), it may not fully reflect the economic contribution of these crucial non-physical assets.

Thes2e limitations highlight that while Adjusted Economic Profit Yield is a powerful tool for performance measurement and value creation, it should be used in conjunction with other financial analyses and a qualitative understanding of the business and its industry.

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

Adjusted Economic Profit Yield and Economic Value Added (EVA) are highly related concepts, often used interchangeably, and both belong to the family of economic profit metrics. The primary distinction lies in how they are presented or the specific emphasis of their calculation, rather than a fundamental difference in their underlying economic principle.

EVA, popularized by Stern Stewart & Co., is a registered trademark and refers to a specific proprietary calculation of economic profit that involves a number of accounting adjustments to Net Operating Profit After Tax (NOPAT) and invested capital to better align them with economic realities. These adjustments aim to remove accounting distortions that might obscure a firm's true economic performance.

Adjusted Economic Profit Yield, while embodying the same core principle of economic profit, is typically presented as a ratio or percentage (e.g., ROIC minus WACC). This "yield" format can make it more intuitive for comparing performance across companies of different sizes or for understanding the percentage return generated above the cost of capital.

The confusion arises because EVA is essentially a dollar-denominated measure of economic profit, whereas "Adjusted Economic Profit Yield" frames this profit as a rate of return. Both seek to measure the extent to which a company's returns exceed its full cost of capital, including the opportunity cost of equity.

FAQs

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

The primary difference is that Adjusted Economic Profit Yield considers both explicit costs (like wages and rent) and implicit costs (like the opportunity cost of capital), while accounting profit only accounts for explicit costs. This means Adjusted Economic Profit Yield provides a more complete picture of a company's true economic performance.

Why is opportunity cost important in calculating Adjusted Economic Profit Yield?

Opportunity cost is crucial because it represents the value of the next best alternative use for a company's resources. By including it, Adjusted Economic Profit Yield ensures that a company's profitability is assessed not just on its earnings, but also on whether those earnings are superior to what could have been achieved with the same capital in an alternative investment. This helps evaluate the true efficiency of resource allocation.

1Can a company have a positive accounting profit but a negative Adjusted Economic Profit Yield?

Yes, this is possible. A company might report a positive accounting profit if its revenues exceed its explicit costs. However, if the implied opportunity cost of the capital used is higher than that accounting profit, the Adjusted Economic Profit Yield will be negative. This signals that while the company is profitable in an accounting sense, it is not generating sufficient returns to cover the full economic cost of its capital, meaning it is destroying shareholder value.