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By David Harper, (Contributing Editor - Investopedia Advisor)
Economic profit - otherwise known as "Economic Value Added" (EVA™) is based on classic financial theory, and, for this reason, is not entirely different from traditional free cash flow measures. Three conceptual pillars support economic profit:
- Cash flows are more reliable than accruals.
- Some period expenses are - in economic reality - actually long-term investments.
- The company does not create value until a threshold level of return is generated for shareholders.
- Economic profit boils down to a set of adjustments that translate an accrual-based earnings before interest and taxes (EBIT) into a cash-based net operating profit after taxes (NOPAT).
- Although the list of potential adjustments is long, it is important not to be seduced into an almost-impossible quest for absolute precision. From an investor's perspective, consistency is more important. That is, an income statement adjustment should always be matched by a balance sheet adjustment. For example, if we add back minority interest to earnings, then we need to add the minority interest balance sheet account to invested capital. We can add neither or both, but there is no truly right answer. In this example, it comes down to whether we prefer our economic profit to have an operational perspective (add both) or a financial perspective (add neither).
- Avoid seeking precision in the calculation of weighted average cost of capital (WACC), a dubious academic exercise. It is far better to charge the company with an approximate but consistent estimate of WACC than to try to chase down the elusive cost of equity. (Several companies, after trying to explain a precise WACC to employees, have come to abandon a precise WACC in favor of a round number like 10%; e.g. "cost of capital is 10%".)
- If you had to rely on only one single performance number, economic profit is probably the best because it contains so much information (mathematicians would call it "elegant"): economic profit incorporates balance sheet data into an adjusted income statement metric.
- Economic profit works best for companies whose tangible assets (assets on the balance sheet) correlate with the market value of assets - as is often the case with mature industrial companies.
- Although some proponents argue economic profit is "all you need", it is very risky to depend on an single metric.
- The companies least suited for economic profit are high-growth, new-economy and high-technology companies, for whom assets are 'off balance sheet' or intangible.
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