Strategic Role of Economic Profit (EP)

The economic profit (EP) matric is a powerful tool to value businesses, evaluate strategies, and measure and evaluate performance. It can also be used to generate wealth for owners of small businesses and large corporations. All firms small or large have a formal or informal strategy with a quest to create value, and therefore, the EP approach can be used to create and maximize shareholder value. This blog article briefly describes how EP can be used to guide the strategic management process by assessing the firm’s or business unit’s profit performance, identifying sources of weak performance, setting goals in terms of EP, and selecting the best strategies.

In the past, several shareholder value measurement metrics have been developed, and among them, economic profit (EP) and its variant economic value added (EVA) are widely known and used to measure economic profit. Economic profit is an appropriate measure of a firm’s profitability and demonstrates the firm’s ability to generate additional value. Economic profit (also known as residual income) differs from accounting profit because it takes into account the cost of capital. The EP measure is defined as follows:

1. EP = Net Operating Profit After Tax (NOPAT) – Cost of Capital

= Net Operating Profit after Tax (NOPAT) – (WACC x Invested Capital)

2. EP = Invested Capital x (ROIC-WACC),

Where ROIC = NOPAT/ Invested Capital, WACC is the weighted

average cost of capital, ROIC is the return on invested capital also

known as return on capital employed (ROCE), and invested capital =

fixed and working capital.

EP describes the real profit in dollars generated by a business in a particular period after adjusting operating profit and invested capital. The accounting net profit, as described in the income statement, does not capture this because it excludes the cost of using equity capital. As equity investors invest their capital in any business, they expect a return on their capital invested, and therefore, EP becomes a vital metric to know the equity investors’ profitability. Calculating EP is not straightforward and requires company balance sheet and income statement data.

According to McKinsey and Company, enterprise value depends on three basic variables:

• Return on capital invested (ROIC)
• The weighted average cost of capital (WACC)
• Growth (g) of operating profit

Since profit and value are tightly linked, EP is also correlated to ROIC, WACC, and growth in profit. Here, profit growth implies that the firm is constantly growing at a rate (g) by reinvesting a portion or percentage of its NOPAT (Investment Rate=Net Investment/NOPAT), and with or without additional capital investment each year to grow the firm. In equation 2.0, the difference between ROIC and WACC establishes a performance spread that is the difference between what a company earns in return and what it pays for its capital to earn that return. Strategic efforts should be made to increase this spread. A positive spread means that a company is making money and creating value, and a negative spread means that the company is running in losses and destroying value.

The EP-based approach can be used to view a company from outside to estimate its value and gauge overall real profitability after removing the cost of capital. It can also be used to look at a company internally to measure, evaluate and correct the firm’s performance. By disaggregating ROIC, the value drivers of performance can be identified. This way, the firm can identify the sources of unsatisfactory performance so that corrective action can be taken to improve performance. By combining EP-based analysis with strategy analysis can facilitate the firm to establish performance objectives and evaluate alternative strategies in the formulation process, and in evaluating performance in the implementation process.

EP is a forward-looking shareholder value measure metric and can easily be incorporated into the financial planning models to predict likely future yearly profit, including the pre-strategy and post-strategy profit differences. The projected EP can further be discounted at the cost of capital to estimate the firm’s value and give the same result using the discounted cash flow (DCF) methodology to evaluate the firm’s value. This value parameter can be compared to the firm’s market capitalization for performance evaluation.

Finally, as the goal of the strategy is to maximize the firm’s value, the application of the EP approach plays a strategic role in accomplishing this goal.

References and Further Reading

1. Dr. Andrew Black, Philip Wright, and John Davies, In Search of Shareholder Value (Great Britain: Pearson Education Limited, 2001), pp. 72-77.
2. Robert M. Grant, Contemporary Strategy Analysis (United Kingdom: John Wiley & Sons, Ltd., 2013), pp. 37-48.
3. Tim Koller, Richard Dobbs, and Bill Huyett, The Four Cornerstones of Corporate Finance (New Jersey: John Wiley & Sons, Inc., 2011), p. 238.
4. Ashok N., “Importance of Shareholder Value in Improving Firm’s Performance,” A&N Strategy Consulting (January 12, 2012).