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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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MEASURING ECONOMIC PROFIT AND VALUE

Annual reports reveal much about the collective view of managers. But rather than finding a sense of shared purpose, we often find overarching goals that vary widely, interpreted and expressed in terms of market share, revenue dollars, gross margins, expense ratios, earnings growth, price/earnings ratios, returns on capital, and share price performance.

Income statement measures still dominate our language in business, yet profit and profit margin measures often drive overproduction, overinvestment, and uneconomic vertical integration because they overlook capital and its cost. And we increasingly see different businesses and business models consuming varying levels of capital at varying costs.

While the goal ultimately must be expressed in terms of shareowner returns, an operating measure provides a more actionable proxy. The contribution to intrinsic value in any given period is best captured with a measure known as economic profit (EP), which is the annual contribution to intrinsic value, or net present value (NPV).1

Economic profit = net operating profit after tax-capital employed × cost of capital

Economic profit measures profit after the cost of all capital employed. It simultaneously captures revenue, cost, and the cost of capital in one measure and properly accounts for the trade-offs between the income statement and balance sheet in creating value. It charges the full cost of your balance sheet to your profit statement.

Economic profit ...

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