By David Harper, (Contributing Editor- Investopedia Advisor)
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Examining the components of economic profit and studying the finer points of its calculation require an understanding of its underlying principles. Here we look at how it matters as a performance measure - which is distinct from a wealth metric - and how it is closely related to market value added (MVA). Finally, in establishing an overall picture of economic profit, we help you undo any perceived complexity by showing how all of the calculations surrounding economic profit originate from three main ideas.

Economic Profit Is a Performance Metric

To understand economic profit, it helps to distinguish between a performance metric and a wealth metric. A performance metric refers to a measure under company control, such as earnings or return on capital. A wealth metric, on the other hand, is a measure of value that - such as equity market capitalization or the price-to-earnings (P/E) multiple -depends on the stock market's collective and forward-looking view. Now, although these two types of metrics are distinct, they are related.

Every performance metric has a corresponding wealth metric. In theory, over the long run, a performance metric can be expected to impact its corresponding wealth metric. For example, consider the matching pair of earnings per share (EPS), a fundamental performance metric, and the P/E multiple, its corresponding wealth metric. The variables that determine EPS - earnings and shares outstanding - are numbers affected only by the company's actions and decisions. On the other hand, the P/E multiple, which is determined by the company's stock price, depends on the value of these actions and decisions assigned by the stock market. The company therefore influences the P/E ratio but cannot fully control it. Here is another way to think about the difference between the two: EPS is a current (or historical) fact but P/E is a forward-looking and collective opinion.

The key criterion for the pairing of a performance and wealth metric is consistency: each half of the pair should reference the same group of capital holders and their respective claims' on company assets. For example, EPS by definition concerns the allocation of earnings to common shareholders; the P/E multiple refers to equity market capitalization, which is the value held by shareholders.

Consider another example: return on capital (ROC) is a performance metric that represents the return both to debt and stockholders, and its corresponding wealth metric is the EBITDA multiple - the value of total debt, plus equity market capitalization (also known as the "enterprise value" or "entity value"), divided by earnings before interest, taxes, depreciation and amortization (EBITDA). This is also called the "price-to-EBIDTA multiple", or "the enterprise multiple". Note how ROC and the EBITDA multiple meet the consistency test. Like ROC, EBITDA captures earnings that accrue to both holders of stock and debt. The EBITDA multiple, therefore, reveals how the market values the company in light of earnings to stockholders and debt-holders.

Below is a chart listing a few performance metrics and their corresponding wealth metrics. Note that economic profit's corresponding wealth metric is market value added (MVA). We explore this relationship below as we come to understand specifically what economic value is and how works:

Performance metric Wealth metric
Return on Equity (ROE), EPS growth P/E Ratio
Return on Capital (ROC or ROIC), Operating Income Growth Ratio of: Entity value ÷ EBITDA
Economic Profit Market Value Added (MVA)
Free Cash Flow Equity Market Capitalization (price x common shares outstanding)
Cash Flow Return on Investment (CFROI) Total Shareholder Return (TSR)

Economic Profit Is Free Cash Flow "Sliced Up"
Financial theory - that is, the discounted cash flow (DCF) model - says that the intrinsic value of a firm equals the present value (also known as "discounted value") of its future free cash flows. In other words, if we are lucky enough to know the future free cash flows, they can be discounted into a single present value. (For a review of how this works, see Understanding the Time Value of Money and Taking Stock of Discounted Cash Flow.) This idea is illustrated below in Figure 1, where the future cash flows (illustrated through to only year five) are discounted to produce a total company value of $40:




Figure 1


Economic profit is based on the same idea. The only difference is that, under economic profit, the intrinsic value of the firm is broken into two parts: invested capital, plus the present value of future economic profits. Here is the comparison:

Traditional Approach
Intrinsic Value = Present Value of Future Free Cash Flows

Economic Profit
Intrinsic Value = Invested Capital + Present Value of Future Economic Profits
As it breaks intrinsic value into parts, you can see why economic profit is often called "residual profit" or "excess earnings". Let's see how this works in Figure 2 below. We are using the same hypothetical assumptions, and the value of the firm's equity remains $40. In this case, however, the green bars in years one through five represent future economic profits, which represent a part of the future free cash flows will therefore always be less than the free cash flows. Later in this chapter we explain the economic calculation of the economic profits, but for now, it's enough to understand that they represent profits earned above the cost of capital.




Figure 2


Economic profits represent the portion of free cash flows after a capital charge is subtracted. In this example, the future economic profits (which we're lucky enough to know) is discounted to a present value of $20 as represented by the tall green bar stacked on top of the dark blue bar, which represents the invested capital portion of $20. Together these contiguous bars show how economic profit divides a company's intrinsic value into two pieces.

The final step in understanding the relationship between these two pieces concerns MVA, which represents how the market values the firm above its invested capital. In our example it is simply the name given to the present value of the future economic profits - the tall green $20 bar. If, for example, this company happened to earn zero future economic profits (zero excess profits), the MVA would be zero, and the company's total value would simply be equal to its invested capital.



Now of course the market does not predict future cash flows (or economic profits) perfectly, so we can speak of MVA in two different ways: the MVA as set by the market and the intrinsic (or theoretical) MVA as set by expected future economic profits. But, just as, according to the traditional valuation model, the firm's market valuation is expected to converge with its discounted free cash flow, the observed MVA is expected to converge with its discounted economic profit value. And here, by "observed MVA" we mean the equity market capitalization, minus the invested capital.

These relationships are illustrated as follows (where → is a symbol for "moves toward becoming the same as"):

Traditional Valuation

Equity Market Capitalization → Discounted [Free Cash Flows] = Intrinsic Value of Firm Equity

Economic Profit Valuation

Equity Market Capitalization → Invested Capital + Discounted [Economic Profit] = Invested Capital + Market Value Added (MVA)

You can now see why economic profit and MVA are a matched pair: discounted economic profits are equal to intrinsic MVA. And the observed MVA (equity market capitalization, minus invested capital) should move toward becoming intrinsic MVA.

Economic Profit: Three Big Steps

Let's now look at the overall calculation, which can be broken down into three sets of calculations. Each of these is the mathematical implication of one of the three main ideas supporting the entire economic profit system:

Idea Implication
1. Cash flows are the best indicators of performance. The accounting distortions must therefore be "fixed". Translate accrual-based operating profit (EBIT) into cash-bashed net operating profit after taxes (NOPAT).
2. Some expenses are really investments and should be capitalized on the balance sheet. True investments must therefore be recognized. Reclassify some current expenses as balance-sheet (equity or debt) items.
3. Equity capital is expensive (or, at the very least, not free). This expense must therefore be accounted for. Deduct a capital charge for invested capital.

Figure 3 below illustrates these ideas:




Figure 3


Let's break this illustration down a little, but don't worry too much about the particulars right now - we cover the details in subsequent sections.

The calculation starts with earnings before interest and taxes (EBIT), which is a pure income-statement (accounting-based) measure. First, several adjustments are made to move the measure nearer to representing actual cash flow (idea #1). Second, certain expense items (i.e. money spent in the current accounting period) are identified as economically really being investments. That is, they are truly meant to create a long-term asset of some sort. Those expenses are then reclassified onto the balance sheet (idea #2).

Those first two steps produce net operating profits after taxes (NOPAT). The idea behind NOPAT is to get a cash-based measure of operating performance. By the way, if you are looking for the exact analog of NOPAT on the income statement, you won't find it. The nearest figure is something we might call "earnings before interest but after taxes" (EBIAT).

Finally, because NOPAT represents profits before the cost of debt service and the cost of equity capital, our next step is to deduct a capital charge (idea #3). The capital charge is what investors, as a group in total, will need to make their investment exactly worthwhile; it could also be called "economic rent". If NOPAT equals the capital charge, then the company just barely met its "rent obligations" to investors - but, in doing so, produced no economic or excess profits. Any NOPAT profits above the capital charge (the small green bars that we examined earlier) are truly in excess and are called economic profits or value added.

Summary
Now you should have a clear picture of the connection between economic profit and market value added: economic profits create MVA. When economic profits are discounted to the present value, they ought to approximate the additional value the market assigns to the company above its invested capital. Finally, the economic profit calculation boils down to three ideas: cash is a better measure of operating performance than accruals, some expenses are truly investments and investment capital is not free. These three ideas will guide all of our calculations through this tutorial.

Next: EVA: Calculating NOPAT »



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