Adjusted economic total return

What Is Adjusted Economic Total Return?

Adjusted Economic Total Return is a financial performance measurement that aims to provide a more comprehensive view of an investment's or a company's true profitability by factoring in both explicit and implicit costs, in addition to typical financial gains. Unlike conventional total return, which primarily considers capital appreciation and income like dividends and interest, Adjusted Economic Total Return seeks to account for the full economic cost of capital and resources utilized. It belongs to the broader category of financial performance measurement, offering a nuanced perspective beyond standard accounting profit. By incorporating the concept of opportunity cost, Adjusted Economic Total Return helps assess whether an entity is genuinely creating economic value or merely generating an accounting profit that might be less than what could have been earned from alternative uses of capital.

History and Origin

The concept of economic profit, which underpins the idea of an "adjusted economic total return," has roots in economic theory that extends beyond simple accounting measures. While the historical evolution of profit calculation dates back centuries, the more modern emphasis on incorporating implicit costs and the true cost of capital gained significant traction with the popularization of Economic Value Added (EVA). EVA, a trademarked variant of residual income, was introduced and popularized by the consulting firm Stern Stewart & Co. in the early 1990s.¹⁹, ²⁰ The firm's founders, Joel Stern and Bennett Stewart, advocated for this measure as a way to quantify true economic profit, arguing that it better reflected shareholder value creation by deducting a capital charge from net operating profit after taxes.¹⁶, ¹⁷, ¹⁸ This approach necessitated adjustments to conventional accounting measures to arrive at a more realistic assessment of surplus value, thereby laying the groundwork for more elaborate "adjusted" total return metrics that move beyond the limitations of reported financial statements.

Key Takeaways

• Adjusted Economic Total Return provides a holistic view of financial performance by including both explicit and implicit costs.
• It helps organizations assess whether their investments generate value above and beyond their true cost of capital, including foregone opportunities.
• Unlike accounting profit, it considers the opportunity cost of resources, making it a valuable internal decision-making tool.
• A positive Adjusted Economic Total Return indicates that an investment or business activity is creating economic value.
• It is often used in performance evaluation, capital budgeting, and strategic resource allocation to optimize shareholder value.

Formula and Calculation

Adjusted Economic Total Return expands on the fundamental concept of total return by integrating economic profit principles. While a precise, universally standardized formula for "Adjusted Economic Total Return" does not exist as a single widely published metric, it can be conceptualized as follows:

Where:

• Total Revenue: The total income generated from sales of goods or services.
• Explicit Costs: Actual, out-of-pocket expenses, such as wages, rent, raw materials, and operating expenses.
• Implicit Costs: The opportunity cost of resources used in the business. This represents the value of the next best alternative use of those resources, which does not involve a direct payment and therefore does not appear on traditional financial statements.
• Capital Charge: The cost of capital employed, representing the minimum rate of return required by investors. This is often calculated using the weighted average cost of capital (WACC) multiplied by the total capital invested.

This formula essentially aims to subtract all economic costs, both explicit and implicit, from total revenue to arrive at a more accurate measure of economic value creation.

Interpreting the Adjusted Economic Total Return

Interpreting the Adjusted Economic Total Return provides critical insights into the genuine value creation of an investment or business operation. A positive Adjusted Economic Total Return suggests that the endeavor is generating returns that exceed all economic costs, including the implicit cost of capital and foregone opportunities. This indicates efficient resource allocation and a net increase in economic wealth. Conversely, a negative Adjusted Economic Total Return implies that the investment is destroying economic value, as the returns are not sufficient to cover all costs, including the opportunity cost of the capital employed. Even if an initiative shows a positive accounting profit, a negative Adjusted Economic Total Return would signal that the resources could have been utilized more profitably elsewhere. This metric is particularly useful for internal decision-making processes, guiding management in capital budgeting, divestment decisions, and prioritizing projects that genuinely add value to the firm.

Hypothetical Example

Consider a small manufacturing business, "GreenTech Solutions," that invested $500,000 in a new, environmentally friendly production line.
Over the past year:

• GreenTech Solutions generated $650,000 in total revenue from this new line.
• Explicit costs (raw materials, labor, utilities) for the line amounted to $400,000.
• The business owner could have invested the $500,000 capital in a diversified portfolio yielding an average annual return on investment (ROI) of 10%. This represents an implicit cost of $50,000 ($500,000 * 0.10).
• The company's weighted average cost of capital (WACC) for this type of project is 8%, leading to a capital charge of $40,000 ($500,000 * 0.08).

First, let's calculate the accounting profit:
Accounting Profit = Total Revenue - Explicit Costs
Accounting Profit = $650,000 - $400,000 = $250,000

Now, let's calculate the Adjusted Economic Total Return:
Adjusted Economic Total Return = Total Revenue - (Explicit Costs + Implicit Costs + Capital Charge)
Adjusted Economic Total Return = $650,000 - ($400,000 + $50,000 + $40,000)
Adjusted Economic Total Return = $650,000 - $490,000 = $160,000

In this hypothetical example, while GreenTech Solutions had a robust accounting profit of $250,000, its Adjusted Economic Total Return is $160,000. This positive figure still indicates that the new production line is economically viable, generating $160,000 more than all its economic costs, including the foregone earnings from an alternative investment and the required return on capital. This analysis is more aligned with the concept of net present value (NPV) by considering the true economic cost of capital.

Practical Applications

Adjusted Economic Total Return serves as a crucial metric in various aspects of financial analysis and strategic management. In corporate finance, it provides a more granular understanding of a project's or business unit's true contribution to shareholder value, moving beyond traditional accounting measures. Companies often use this metric to evaluate the effectiveness of their resource allocation decisions, ensuring that capital is deployed in ventures that not only generate revenue but also exceed the economic cost of funds. For instance, firms might apply an adjusted economic total return analysis when assessing potential mergers and acquisitions, new product launches, or significant capital expenditures, as it helps determine if these initiatives will genuinely enhance long-term value.

Furthermore, it plays a role in internal performance measurement and incentive compensation, particularly in large organizations with diverse business units. By linking management bonuses to Adjusted Economic Total Return, companies can align managerial interests with overall economic value creation, discouraging decisions that might boost short-term accounting profit but destroy long-term economic value. Investment firms, such as Research Affiliates, often employ sophisticated models that incorporate various factors and economic considerations to assess portfolio performance and asset allocation, implicitly reflecting the principles behind adjusted returns.

Limitations and Criticisms

While Adjusted Economic Total Return offers a more comprehensive view of performance, it also presents several limitations and criticisms. A primary challenge lies in the subjective nature of estimating implicit costs and accurately determining the weighted average cost of capital (WACC). Unlike explicit costs, which are recorded on financial statements, implicit costs often require estimations of foregone opportunities, which can be speculative and vary depending on the assumptions made. This subjectivity can make it difficult to consistently calculate and compare Adjusted Economic Total Return across different companies or even within the same company over time.¹³, ¹⁴, ¹⁵

Another criticism is that, similar to other non-GAAP financial measures, Adjusted Economic Total Return is not standardized by generally accepted accounting principles (GAAP).¹¹, ¹² This lack of standardization means that companies can adopt different methodologies for its calculation, potentially leading to inconsistencies and making external comparability challenging. The U.S. Securities and Exchange Commission (SEC) has provided guidance on the use of non-GAAP measures, emphasizing the need for clear reconciliation to the most comparable GAAP measure and cautioning against their use in a misleading manner.⁸, ⁹, ¹⁰ Moreover, focusing solely on a single metric, even one as comprehensive as Adjusted Economic Total Return, might lead to an overly narrow view of a company's financial health, potentially overlooking other important qualitative and quantitative factors. Some argue that it may also incentivize short-term gains if not carefully structured within corporate governance frameworks, as managers might prioritize immediate economic profits over long-term strategic investments.⁷

Adjusted Economic Total Return vs. Economic Profit

While closely related and often used interchangeably in discussions of economic performance, "Adjusted Economic Total Return" and "Economic Profit" have subtle differences in their scope and typical application.

Economic Profit (also known as "economic value added" or "residual income") focuses on the difference between the net operating profit generated by a business and the capital charge, which is the cost of the capital employed. It is a measure of a company's success in creating wealth above and beyond the minimum required return for its investors. The core idea is to account for the opportunity cost of capital, ensuring that profitability is assessed after considering alternative investment opportunities.

Adjusted Economic Total Return, as conceived, expands upon the principles of economic profit to encompass a broader "total return" perspective. While Economic Profit primarily measures the profit generated in excess of capital costs, Adjusted Economic Total Return implies a more encompassing measure that could incorporate all forms of return (capital appreciation, dividends, etc.) and then subject them to a rigorous economic cost analysis, including explicit, implicit, and capital costs. Essentially, Adjusted Economic Total Return takes the "total return" from an investment and then "adjusts" it by subtracting all economic costs, leading to a net economic gain or loss over a period. Economic Profit is a component of this broader adjustment.

The confusion arises because both metrics emphasize the inclusion of implicit costs and the cost of capital, moving beyond traditional accounting profit. However, Economic Profit is often seen as a direct measure of economic surplus from operations, while Adjusted Economic Total Return aims to present the total financial outcome of an investment or project after a comprehensive economic cost deduction.

FAQs

What is the primary difference between Adjusted Economic Total Return and accounting profit?

The primary difference is the inclusion of implicit costs and a capital charge in Adjusted Economic Total Return. Accounting profit only subtracts explicit costs (like wages, rent, and materials) from revenue to arrive at a net income. Adjusted Economic Total Return, conversely, also accounts for the opportunity cost of capital and resources, providing a truer measure of economic value creation.⁵, ⁶

Why is opportunity cost important in calculating Adjusted Economic Total Return?

Opportunity cost is crucial because it represents the value of the next best alternative use of a company's resources. Including this implicit cost in Adjusted Economic Total Return helps assess whether the current investment is truly the most efficient and profitable use of capital, ensuring that the return isn't just positive in accounting terms but also economically superior to other options.⁴

Is Adjusted Economic Total Return reported on a company's financial statements?

No, Adjusted Economic Total Return is not typically reported on a company's official financial statements. It is a non-GAAP (Generally Accepted Accounting Principles) measure primarily used for internal analysis, strategic decision-making, and performance evaluation. Financial statements adhere to specific accounting standards, which generally do not include implicit costs or subjective capital charges.², ³

How does Adjusted Economic Total Return help in investment decisions?

Adjusted Economic Total Return provides a more realistic assessment of an investment's profitability by considering all economic costs, including the cost of capital. For investors, a positive Adjusted Economic Total Return indicates that an investment is creating value above its true economic cost, making it a more attractive option compared to those that might show an accounting profit but fail to cover their full economic burden. It helps in evaluating the long-term economic viability and value-adding potential of an investment.

Can a company have a positive accounting profit but a negative Adjusted Economic Total Return?

Yes, it is entirely possible for a company to report a positive accounting profit but still have a negative Adjusted Economic Total Return. This occurs when the accounting profit is high enough to cover explicit costs but not high enough to cover the implicit costs or the capital charge (the return that could have been earned from alternative investments of similar risk). A negative Adjusted Economic Total Return signals that while the business is profitable on paper, it is not generating sufficient value to justify the use of its capital and resources compared to other available opportunities.¹