What is Economic Profit?
Economic profit is a measure of performance that compares net operating profit to total cost of capital.
How Does Economic Profit Work?
Economic profit is also referred to as economic value added (EVA), which is a trademarked concept originally devised by Stern Stewart & Co.
The formula for economic profit is:
Economic Profit = Net Operating Profit After Tax - (Capital Invested x WACC)
As shown in the formula, there are three components necessary to solve economic profit: net operating profit after tax (NOPAT), invested capital, and the weighted average cost of capital (WACC).
The net operating profit after tax (NOPAT) can be found on the corporation's income statement, or calculated if preferred.
Capital invested is the amount of money used to fund a particular project. We will also need to calculate the weighted-average cost of capital(WACC) if the information is not already provided.
The purpose of multiplying WACC and capital investment is to assess a charge for using the invested capital. This charge is the amount that investors as a group need to make their investment worthwhile.
Let's take a look at an example.
Assume that Company XYZ has the following components to use in the economic profit formula:
NOPAT = $3,380,000
Capital Investment = $1,300,000
WACC = .056 or 5.60%
Economic Profit = $3,380,000 - ($1,300,000 x .056) = $3,307,200
The positive number tells us that Company XYZ more than covered its cost of capital. A negative number indicates that the project did not make enough profit to cover the cost of doing business.
Why Does Economic Profit Matter?
Economic profit is important because it is used as an indicator of how profitable company projects are and it therefore serves as a reflection of management performance.
Economic profit attempts to prove that businesses are only truly profitable when they create wealth for their shareholders, and the measure of this goes beyond calculating net income. Economic profit asserts that businesses should create returns at a rate above their cost of capital
The economic profit calculation has many advantages. It succinctly summarizes how much and from where a company created wealth. It includes the balance sheet in the calculation and encourages managers to think about assets as well as expenses in their decisions.
However, the seemingly infinite cash adjustments associated with calculating economic profit can be time-consuming. Accrual distortions may also affect the measure, particularly when it comes to depreciation and amortization differences. Also, economic profit only applies to the period measured; it is not predictive of future performance, especially for companies in the midst of reorganization and/or about to make large capital investments.
The economic profit calculation depends heavily on invested capital, and it is therefore most applicable to asset-intensive companies that are generally stable. Thus, economic profit is more useful for auto manufacturers, for example, than software companies or service companies with a lot of intangible assets.