What Is Advanced Economic Profit?
Advanced Economic Profit, often referred to as Economic Value Added (EVA), is a financial performance measurement that aims to quantify a company's true economic profitability by accounting for the full cost of capital, including the opportunity cost of equity. Unlike traditional accounting profit, which primarily considers explicit costs, Advanced Economic Profit delves deeper into the financial health of an enterprise by subtracting the cost of all capital employed to generate revenue. This approach provides a more comprehensive view of whether a business is genuinely creating shareholder value above and beyond the minimum return required by its investors.
Within the broader category of financial performance measurement, Advanced Economic Profit is a powerful financial metric used to assess how effectively a company is utilizing its capital. A positive Advanced Economic Profit indicates that the company is generating a return greater than its cost of capital, thereby creating wealth. Conversely, a negative Advanced Economic Profit suggests that the company is not covering its capital costs, implying value destruction.
History and Origin
The concept of economic profit has roots in economic theory, recognizing that true profit must account for the implicit costs of capital. However, the specific measure of Advanced Economic Profit, popularized as Economic Value Added (EVA), was developed and trademarked by the management consulting firm Stern Stewart & Co. in the late 1980s and early 1990s.28, 29 This methodology emerged as a practical refinement of the economic concept of residual income, aiming to provide a more precise measure of a company's financial performance and the value it creates for its shareholders than traditional accounting measures.26, 27 Stern Stewart's goal was to introduce a model for maximizing value that could also be used to incentivize management at all levels of a firm. Today, Stern Stewart & Co. operates as Stern Value Management, continuing to promote the principles of value creation.
Key Takeaways
- Advanced Economic Profit (EVA) measures a company's true profitability by deducting the cost of capital from its operating profit.
- It accounts for the opportunity cost of capital, which traditional accounting methods do not.
- A positive Advanced Economic Profit indicates that a company is creating wealth for its shareholders, exceeding the minimum required return on invested capital.
- The calculation encourages managers to make decisions that align with long-term shareholder value creation.
- It is a non-Generally Accepted Accounting Principles (non-GAAP) measure and requires adjustments to standard financial statements.
Formula and Calculation
The core formula for Advanced Economic Profit (EVA) integrates a company's operational performance with its capital costs. It is typically calculated as:
Where:
- NOPAT (Net Operating Profit After Taxes): Represents the company's operating profit after deducting taxes, but before accounting for interest expenses. It measures the profits generated from the company's core operations.25
- Invested Capital: The total capital employed by the company to generate its net operating profit after taxes. This typically includes debt, capital leases, and shareholders' equity.
- WACC (Weighted Average Cost of Capital): The average rate of return a company expects to pay its investors for using their capital. It is a weighted average of the cost of equity and the cost of debt, reflecting the overall cost of financing a company's assets.24
The formula can also be expressed as:
This alternative formula highlights the "return spread," demonstrating that value is created when the return on invested capital exceeds the weighted average cost of capital.22, 23
Interpreting the Advanced Economic Profit
Interpreting Advanced Economic Profit involves understanding whether a business is truly adding value. A positive Advanced Economic Profit figure indicates that the company's operations are generating returns that exceed the cost of the capital employed. This means the business is not only covering its operational expenses and taxes but also providing an adequate return to its debt and equity holders, thereby creating shareholder value. Such a result suggests efficient capital allocation and effective management of resources.
Conversely, a negative Advanced Economic Profit signifies that the company's returns are not sufficient to cover its cost of capital. In this scenario, even if the company reports an accounting profit, it is effectively destroying economic value, as the capital invested could yield higher returns elsewhere. A zero Advanced Economic Profit means the company is earning just enough to cover its cost of capital, indicating it is generating a "normal profit" and maintaining its economic viability but not creating additional wealth beyond the opportunity cost of capital.
Hypothetical Example
Consider "InnovateTech Inc.," a software company launching a new product line.
- Total Revenue: $10,000,000
- Operating Expenses (excluding taxes and interest): $6,000,000
- Tax Rate: 25%
- Total Invested Capital: $15,000,000
- Weighted Average Cost of Capital (WACC): 10%
Step 1: Calculate NOPAT
NOPAT = Operating Income × (1 - Tax Rate)
Operating Income = Total Revenue - Operating Expenses = $10,000,000 - $6,000,000 = $4,000,000
NOPAT = $4,000,000 × (1 - 0.25) = $4,000,000 × 0.75 = $3,000,000
Step 2: Calculate Capital Charge
Capital Charge = Invested Capital × WACC
Capital Charge = $15,000,000 × 0.10 = $1,500,000
Step 3: Calculate Advanced Economic Profit
Advanced Economic Profit = NOPAT - Capital Charge
Advanced Economic Profit = $3,000,000 - $1,500,000 = $1,500,000
In this hypothetical example, InnovateTech Inc. has an Advanced Economic Profit of $1,500,000. This positive figure indicates that the new product line is generating value above and beyond the cost of the capital invested. This insight would be valuable for strategic planning and for assessing the efficiency of resource utilization for this project.
Practical Applications
Advanced Economic Profit is widely applied in various areas of finance and business management to enhance decision-making and performance evaluation. For instance, companies use it in capital allocation to identify projects or business units that generate returns exceeding their cost of capital, thereby guiding investment towards the most value-creating opportunities. By f19, 20, 21ocusing on this metric, management is incentivized to invest in projects that truly enhance shareholder value.
It also serves as a robust tool for internal performance evaluation, helping to align the interests of managers with those of shareholders. Managers are encouraged to make decisions that not only increase operating profits but also manage the capital base efficiently. Furthermore, Advanced Economic Profit can be used for benchmarking, allowing companies to compare their true economic performance against competitors, offering a more level playing field than traditional measures. The 18Federal Reserve Bank of San Francisco (FRBSF) has noted the importance of understanding profit rates relative to the cost of capital for both public and private companies in assessing economic activity.
17Limitations and Criticisms
Despite its advantages, Advanced Economic Profit has several limitations. One significant criticism is its reliance on accounting data, which can be influenced by various accounting choices and assumptions, such as depreciation methods or capitalization policies. These assumptions can lead to distortions in the calculation of net operating profit after taxes (NOPAT) and invested capital, potentially misrepresenting the true economic value created.
Ano15, 16ther limitation is the subjectivity involved in estimating the weighted average cost of capital (WACC). Determining the appropriate discount rate involves assessments of risk, market conditions, and future interest rates, which can introduce variability into the Advanced Economic Profit calculation. Diff13, 14erent methodologies for WACC can yield different results, making comparisons challenging. Additionally, critics argue that the focus on annual or quarterly data for Advanced Economic Profit can sometimes encourage short-term decision-making to boost the metric, potentially at the expense of long-term investments like research and development, which might not immediately yield returns but are crucial for future growth.
Fur11, 12thermore, as a non-GAAP financial measure, Advanced Economic Profit requires careful presentation and reconciliation to comparable GAAP measures to avoid being misleading, as highlighted by guidance from the U.S. Securities and Exchange Commission (SEC). The 8, 9, 10SEC scrutinizes non-GAAP measures to ensure they provide transparent and non-misleading information to investors. Some6, 7 argue that such customized financial metrics can be challenging to implement consistently across an organization and may not fully capture qualitative aspects of performance, as discussed in broader critiques of performance measurement.
5Advanced Economic Profit vs. Accounting Profit
The primary distinction between Advanced Economic Profit and accounting profit lies in the costs they consider. Accounting profit, typically reported on a company's income statement, is calculated as total revenue minus explicit costs. Explicit costs are direct, out-of-pocket expenses such as wages, rent, utilities, and raw materials—the costs that appear on a company's financial statements.
In co3, 4ntrast, Advanced Economic Profit (or economic profit) subtracts both explicit and implicit costs from total revenue. The crucial addition of implicit costs accounts for the opportunity cost of using capital and other resources in their current application rather than their next best alternative. For in1, 2stance, if a business owner invests their own capital into a venture, the implicit cost would be the foregone return they could have earned by investing that capital elsewhere (e.g., in a bond or another business). Therefore, Advanced Economic Profit provides a more comprehensive view of true profitability, revealing whether a business is generating returns that exceed the minimum required to keep its resources in their current use. If a company has a positive accounting profit but a negative Advanced Economic Profit, it suggests that while it's making money on paper, it's not generating sufficient returns to justify the capital employed from an economic perspective.
FAQs
What is the main purpose of Advanced Economic Profit?
The main purpose of Advanced Economic Profit is to provide a more accurate measure of a company's true profitability by factoring in the full cost of capital, including the implicit opportunity cost. This helps assess whether a business is genuinely creating shareholder value above and beyond the minimum required return.
How does Advanced Economic Profit differ from traditional profit?
Advanced Economic Profit differs from traditional accounting profit by including both explicit costs (direct, out-of-pocket expenses) and implicit costs (such as the opportunity cost of capital). Accounting profit only considers explicit costs. This means Advanced Economic Profit provides a more holistic view of a company's financial performance.
Can a company have a positive accounting profit but a negative Advanced Economic Profit?
Yes, a company can have a positive accounting profit but a negative Advanced Economic Profit. This occurs when the company's revenues exceed its explicit costs, resulting in an accounting profit, but this profit is not sufficient to cover the full cost of capital (both explicit and implicit costs). In such a scenario, the company is not generating enough value to justify the resources employed from an economic standpoint.
Is Advanced Economic Profit used by all companies?
While Advanced Economic Profit (EVA) is a valuable tool, it is not universally adopted by all companies. It is often favored by larger corporations and those with significant invested capital seeking to enhance their capital allocation and align management incentives with shareholder value creation. However, its complexity and reliance on subjective estimates, such as the weighted average cost of capital, can be a deterrent for some.