What Is Economic Profit?
Economic profit represents the true profitability of a business, going beyond conventional accounting figures to include both explicit and implicit costs. Within the realm of Corporate Finance, it measures the surplus value generated by a company after all costs, including the Opportunity Cost of the capital employed, have been covered. This crucial metric provides a more comprehensive view of Financial Performance, indicating whether a company is truly creating wealth for its shareholders or merely covering its operational expenses. Economic profit is a valuable tool for assessing a firm's efficiency in resource allocation and its ability to generate returns above the minimum required by investors.12
History and Origin
The concept of economic profit, which accounts for the cost of all capital, has roots in classical economic theory. However, its modern application and popularization in corporate finance, particularly through the framework of Economic Value Added (EVA), are largely attributed to Joel Stern and G. Bennett Stewart III of Stern Stewart & Co.10, 11 Beginning in the 1970s, Joel Stern articulated the limitations of traditional accounting profits, advocating for a measure that captured the true cost of equity capital.9 The consulting firm formally launched the EVA concept in the early 1990s, promoting it as a revolutionary tool for measuring and incentivizing value creation within companies.7, 8 This approach aimed to align management decisions with Shareholder Value by emphasizing that a company only creates wealth if its returns exceed its Cost of Capital.
Key Takeaways
- Economic profit accounts for both explicit accounting costs and implicit opportunity costs, including the cost of capital.
- A positive economic profit indicates that a business is generating returns above the minimum required by investors, thereby creating value.
- It serves as a more accurate measure of a company's true value creation compared to traditional accounting profit.
- Economic profit is a key metric in evaluating Investment Decisions and capital allocation efficiency.
- The concept is closely related to Economic Value Added (EVA), a proprietary metric popularized by Stern Stewart & Co.
Formula and Calculation
Economic profit is calculated by subtracting the total cost of capital from a company's Net Operating Profit After Tax (NOPAT). The total cost of capital is typically determined by multiplying the invested capital by the Weighted Average Cost of Capital (WACC).
The formula for Economic Profit (EP) is:
Alternatively, it can be expressed in terms of return on invested capital:
Where:
- $NOPAT$ = Net Operating Profit After Tax, which is a company's profit from operations after accounting for taxes but before interest payments.
- $Invested\ Capital$ = The total capital a company has employed in its operations (e.g., debt + equity + capital leases).
- $WACC$ = Weighted Average Cost of Capital, representing the average rate a company expects to pay to finance its assets.
- $ROIC$ = Return on Capital (Return on Invested Capital), which measures how well a company is generating profits from all its capital.
Interpreting the Economic Profit
Interpreting economic profit provides critical insights into a company's value creation. If a company generates a positive economic profit, it signifies that it is earning more than the minimum return necessary to compensate its capital providers for the risk undertaken and the alternative uses of their capital. This indicates true value creation for shareholders and a strong Competitive Advantage.
Conversely, a negative economic profit suggests that the company is not covering its full cost of capital, implying that value is being destroyed, even if the company reports a positive accounting profit. A zero economic profit, often referred to as normal profit, means the company is earning just enough to cover all its costs, including the opportunity cost of capital. This implies that resources are being used in their most efficient way but no additional surplus value is being generated. Analyzing trends in economic profit helps investors and managers evaluate long-term viability and the effectiveness of Capital Allocation strategies.
Hypothetical Example
Consider "Alpha Tech," a software company, that is evaluating a new project requiring an initial Capital Allocation of $10 million. Alpha Tech's Weighted Average Cost of Capital (WACC) is estimated to be 10%.
After one year of operations, the new project generates a Net Operating Profit After Tax (NOPAT) of $1.2 million.
Step 1: Calculate the Cost of Capital for the project.
Cost of Capital = Invested Capital × WACC
Cost of Capital = $10,000,000 × 10% = $1,000,000
Step 2: Calculate the Economic Profit.
Economic Profit = NOPAT - Cost of Capital
Economic Profit = $1,200,000 - $1,000,000 = $200,000
In this hypothetical example, Alpha Tech's new project generated an economic profit of $200,000. This positive result indicates that the project not only covered its operational costs and taxes but also generated a return above the cost of the capital invested, thereby creating additional value for the company and its shareholders.
Practical Applications
Economic profit is a versatile metric used across various facets of finance and business analysis. In Valuation Models, it is a foundational element, particularly within frameworks like Economic Value Added (EVA), to assess a company's intrinsic worth. Analysts often incorporate economic profit to evaluate whether a company is truly creating value, which is crucial for Investment Decisions.
Companies also use economic profit internally for performance measurement, informing executive compensation schemes to align managerial incentives with shareholder wealth creation. It helps in rigorous Capital Allocation by providing a clear hurdle rate: projects should only be pursued if their expected returns exceed the cost of capital, leading to a positive economic profit. Furthermore, it plays a role in strategic planning, guiding management towards initiatives that build sustainable Shareholder Value. The Weighted Average Cost of Capital (WACC), a key input to economic profit, is widely used as a hurdle rate for investment projects, meaning companies typically accept projects with expected returns greater than their WACC.
6## Limitations and Criticisms
Despite its theoretical appeal and practical utility, economic profit, particularly through its widely recognized application as Economic Value Added (EVA), faces several limitations and criticisms. One significant challenge lies in its Complex Calculation. Accurately determining NOPAT and invested capital often requires numerous accounting adjustments to reported Financial Statements, which can be subjective and vary between analysts. F4, 5or instance, the treatment of research and development expenses or operating leases can significantly impact the calculation.
Another critique is the potential for a short-term focus. While economic profit is designed to promote long-term value creation, managers incentivized solely on short-term economic profit might defer crucial long-term investments, such as Risk Adjustment initiatives or new product development, that could negatively impact current NOPAT but yield significant future returns. M2, 3oreover, economic profit models, including EVA, are generally better suited for asset-heavy companies and may not accurately reflect value creation in businesses with substantial intangible assets, such as technology or service industries. The concept's popularity has also been observed as a "management fashion," with periods of heightened adoption followed by declines as other metrics gain prominence.
1## Economic Profit vs. Accounting Profit
The distinction between economic profit and Accounting Profit is fundamental in finance and economics, primarily revolving around the types of costs considered.
| Feature | Accounting Profit | Economic Profit |
|---|---|---|
| Costs Included | Explicit costs only (e.g., wages, rent, materials, taxes, interest). | Explicit costs plus implicit costs (opportunity costs, including the cost of equity capital). |
| Calculation | Total Revenue - Explicit Costs | Total Revenue - (Explicit Costs + Implicit Costs) OR NOPAT - Cost of Capital |
| Purpose | Measures reported financial performance. | Measures true value creation beyond required returns. |
| Perspective | Financial reporting and tax purposes. | Economic decision-making, resource allocation, and shareholder value. |
| Outcome | Can be positive even if the business isn't truly creating value. | A positive result indicates value creation; zero indicates normal profit; negative indicates value destruction. |
While accounting profit reflects the net income reported on a company's income statement, economic profit delves deeper by incorporating the Opportunity Cost of all resources. For example, accounting profit does not explicitly deduct the cost of equity capital (the return shareholders could earn elsewhere with similar risk), whereas economic profit does. This distinction is crucial for understanding whether a business is genuinely adding value or simply maintaining its position.
FAQs
What does a positive economic profit mean?
A positive economic profit indicates that a company is generating returns that exceed all its costs, including the implicit cost of capital. This means the company is creating value for its shareholders above and beyond what they could earn by investing in an alternative with similar risk.
How does economic profit differ from normal profit?
Normal profit is a situation where a company's economic profit is zero. It signifies that the company is earning just enough to cover all its explicit and implicit costs, including the opportunity cost of capital. While no surplus value is created, the business is economically viable and its resources are being used efficiently.
Is economic profit reported on financial statements?
No, economic profit is not typically reported on a company's standard Financial Statements. It is a concept derived from economic theory and used for internal managerial analysis and external valuation, requiring adjustments to traditional accounting figures.
Why is the Weighted Average Cost of Capital (WACC) important for economic profit?
The Weighted Average Cost of Capital (WACC) is a critical component of calculating economic profit because it represents the minimum acceptable rate of return a company must generate on its invested capital to satisfy all its investors (both debt and equity holders). By incorporating WACC, economic profit directly measures if a company's returns surpass this hurdle rate.
Can a company have an accounting profit but a negative economic profit?
Yes, this is a common scenario. A company can report a positive Accounting Profit if its revenues exceed its explicit costs. However, if those revenues are not sufficient to also cover the implicit cost of the capital employed (what investors could have earned elsewhere), then the company will have a negative economic profit, indicating it is destroying value from an economic perspective.