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By David Harper, (Contributing Editor - Investopedia Advisor)
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As we performed a sequence of calculations to find Disney's (DIS) 2004 economic profit, we discovered that despite positive accounting earnings, the company produced negative economic profit. Now that we've gone over the components of economic profit and the steps to finding it, in this chapter, we want to achieve three things: (1) itemize a list of core adjustments you should consider if you want to calculate economic profit for a company, (2) put into perspective the economic profit metric by comparing it to alternative metrics and (3) consider the key strengths and weakness of the economic profit metric.

The Recap

Now that you've viewed economic profit in action, you've likely observed that most of its perceived complexity results from two types of adjustments that convert accounting earnings into net operating profit after taxes (NOPAT). The goal of these adjustments is to translate an accounting profit into an economic profit that more accurately reflects cash invested and cash generated. The illustration below recaps the process.

Figure 1

To make the conversion, we can start with any income statement line, but it is easiest to start with earnings before interest and taxes (EBIT). Then we make two types of adjustments in order to convert EBIT into NOPAT. First, we reverse accruals to capture cash flows, and second, we capitalize expenses that ought to be treated like investments. Once we have NOPAT, we need only to subtract the capital charge, which is equal to total invested capital - which we find by making appropriate adjustments to invested book capital, found on the balance sheet - multiplied by the weighted average cost of capital (WACC).

The Core Adjustments
Remember the importance of being consistent throughout the course of your calculations: always match an income statement adjustment - in getting NOPAT - to a corresponding balance sheet adjustment - in getting invested capital. This is more important than the number of your adjustments!

The "perfect" economic profit calculation is fully loaded; that is, it captures every dollar of invested capital and makes every adjustment to determine the precise level of cash flow. But the need for a perfect economic profit number is questionable. Many academic studies have demonstrated that the incremental information gained beyond a handful of key adjustments is minimal. You are therefore okay to use a few adjustments to arrive at an approximation.

The table below shows a list of selected core adjustments. Each income statement adjustment in the left-hand column helps to convert EBIT to NOPAT; each corresponding balance sheet adjustment in the right-hand column helps convert book capital to invested capital.

Putting Economic Profit into Perspective
To determine what economic profit tells us as an analytical tool for investors, we need to compare it to several other popular metrics. Let's start by determining the levels of analysis: does the metric capture dollars created for the entire entity (both lenders and shareholders) or only the shareholders, or does it capture excess (residual) dollars created for both shareholders and lenders? Figure 2 below summarizes which levels of analysis the different types of valuation metrics occupy, and it indicates which are performance metrics and which are wealth metrics.

Figure 2

In Figure 2, the levels of analysis are labeled across the top row. Under entity, we show two columns of metrics: before reinvestment and after reinvestment. These columns distinguish between those metrics that include capital expenditures and those that don't. For example, EBITDA is before depreciation and amortization (D&A) and therefore is before the non-cash charge that reduces earnings by the amortized investment. But EBIT is after D&A and, although not cash based, does recognize a charge for investments.

Down the left-hand side we have three rows of performance metrics and one row of wealth metrics. The first row of performance metrics shows accrual metrics, which are based on accounting flows, and below each accrual metric is the cash flow metric analog based on the same level of analysis. For example, the cash flow analog to EBIT is free cash flow to the firm (FCFF). EBIT is the earnings that accrue to both shareholder and lenders - in other words, it accrues to the entire entity or enterprise. And FCFF is the equivalent in cash flows.

By looking at the chart, you may be asking yourself what the difference is between economic profit and cash value added (CVA), both of which are residual dollar returns. Despite its use of adjustments, economic profit is essentially accrual based. Consider NOPAT's inclusion of - or put another way, reduction by - depreciation and amortization, which are non-cash charges. So, whatever adjustments we make, we are still incorporating accruals. CVA, on the other hand, is a metric designed to correct/reverse this by adding back the non-cash charges of depreciation and amortization.

Figure 2 also shows how the performance metrics - whether capturing enterprise, shareholder or residual dynamics - have corresponding return metrics and wealth metrics. Return on gross invested capital (ROGIC), for example, corresponds to EBITDA because it adds back depreciation to capital in the denominator - ROGIC is before D&A just as EBITDA is before D&A. (ROGIC is similar to return on gross assets (ROGA).)

Economic spread, which expresses economic dollars in percentage terms, is the returns-metric analogue to economic profit. To understand this, we simply rearrange our basic economic profit calculation:

Economic profit = NOPAT - [WACC × Invested Capital] (NOPAT = ROIC × Invested Capital)

Economic profit = [ROIC × Invested Capital] - [WACC × Invested Capital] Economic profit = [ROIC - WACC] × Invested Capital

The difference between return on invested capital (ROIC) and the weighted average cost of capital is the economic spread: spread = [ROIC – WACC].

Strengths and Weaknesses of Economic Profit

The map of metrics above helps us to understand that economic profit it is one of several valid performance measures, each of which offer a different type of insight into a company. Economic profit's strengths include the following:
  • Because it is a residual performance metric, it conveniently summarizes into a single statistic the value created above and beyond all financial obligations
  • By applying a capital charge, it corrects the key deficiency of earnings and earnings per share (EPS): they do not incorporate the balance sheet. Economic profit explicitly recognizes - by way of the capital charge - that capital is not free and, if growth is purchased with capital, economic profit recognizes that the growth is not free and assigns a charge for the capital used to purchase the growth.
  • As an operational metric, it helps managers clarify how they create value. Generally, they do it either by investing additional capital that produces returns above WACC, by reducing capital employed in a business, by improving returns by growing revenues or reducing expenses or by reducing the cost of capital.
Now consider the weaknesses of economic profit:
  • Unless fully loaded and all cash adjustments are made, economic profit can be subject to accrual distortions. For example, because NOPAT is after depreciation and amortization, a company that does not reinvest capital to maintain its plant and equipment can improve its accrual bottom line simply by virtue of the declining D&A line. This sort of attempt at boosting economic profit is known as harvesting the assets.
  • It has the limitations of any single-period, historical metric: last year's economic profit will not necessarily give you an insight into future performance. This can be especially true if a company is in a turnaround situation or makes a large lump-sum investment, in which case, economic profit will immediately suffer (due to the higher invested capital base) but the expected future period payoff will not show up as a benefit in the calculation.
Because it relies on invested capital, it is more suitable for analyzing asset-intensive firms (those whose value comes largely from tangible assets on the balance sheet) that exhibit somewhat predictable growth trends. The best use of economic profit tends to be in traditional and mature industries. It therefore has less relevance for firms that are valuable largely because of intangible, off-balance-sheet assets; economic profit has shown limited success in high-tech and service-oriented companies.

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