Economic Profit
It is what remains of the net revenue after all the explicit and implicit costs are deducted.
It is what remains of the net revenue after all the Explicit and Implicit costs are deducted.
There are two variables while calculating the eco-profits:
Explicit costs or operating costs
Implicit costs or opportunity costs.
When opportunity costs are deducted from the pre-tax or accounting profit, we get economic profit.
Economists define it as the difference between the Total Revenue (TR) and Economic Costs. They are nothing but Opportunity Costs.
It is achieved when the Marginal Revenue Curve (MRC) is above the average total cost curve.
If a firm has shown consistent economic profits, then it can be said that the firm has competitive advantages and well-defined moats.
Formula
Economic Profit, in its essence, is what remains after opportunity cost is deducted from the accounting profit (i.e., Total Revenue - Explicit Costs). There are three components to the formula; Total Revenue, Explicit Costs, and Opportunity Cost.
Total Revenue is the net reported revenue of the firm. It is the revenue left after refunds, returns, and discounts are accounted for.
Explicit Costs are the normal business expenses that are reported on the income statement of a company.
Explicit costs are also referred to as operating costs which, after being deducted from the net revenue of a business, can give us the before-tax profit of a firm, also referred to as the accounting profit.
Explicit costs can be classified into two sub-categories:
SG&A:
Selling, General & Administrative expenses include all the company expenses that are not included in the production or delivery of goods and services; rent & utilities, advertising costs, equipment costs, and salary expenses are the type of expenses included in SG&A.COGS
The cost of goods sold includes all the costs that are necessary in order to create the finished product that is sold by the business. COGS includes costs like raw materials, freight charges, storage, factory overheads, cash discounts, etc. It is basically the cost necessary to turn the raw material into finished inventory which can sit on the balance sheet of a company.
Other expenses like interest payments and R&D expenses are independent line items but are also included in explicit costs.
The opportunity cost is what differentiates accounting profit from eco-profit. As the name suggests, the opportunity cost is the cost of a forgone benefit that would have been indulged if a different option was chosen.
Example
Mr. John Smith, an investment manager, chooses to invest his client's money into a fixed income instrument like a high-yield corporate debt instrument giving 5% interest per annum.
The opportunity cost for Mr. John Smith would be not investing in a higher returning security like an S&P 500 ETF which has averaged an 8% CAGR over the past decade.
So the Opportunity Cost: 8% - 5% = 3% is the opportunity cost for Mr. John Smith.
Understanding & Interpreting Economic Profits
It happens when a business can cover its explicit or operating costs along with the opportunity cost foregone.
There are several factors that are instrumental in generating it. Some of them include huge tailwinds, competitive advantages, and a strong operational framework or even cheap credit, which drives down the total cost of capital.
It is an indication of a good profitable business that is sustainable in the long run as it is able to cover all of its fixed and variable costs along with any opportunity costs. As the firm is operating well above its shutdown point, and break-even point (BEP)
If a firm can just cover its average variable costs (AVC), then the firm is said to operate just above its shutdown point and should not continue operations.
At the same time, if a firm can cover its average total cost (ATC), it means that it is earning eco-profits where the Return on Equity (ROE) is higher than the Required Rate of Return (RRR).
Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC)
Eco-Profits are categorized into two types.
Normal Eco-Profits
Abnormal Eco-Profits
Normal Economic Profit
Also known as normal profit, it is when a firm can cover its explicit and opportunity costs but cannot earn over and above those costs.
In this scenario, a firm can only cover its required rate of return.
ROE = RRR
This scenario is also referred to as a zero economic profit where the firm can cover its operating expenses and required rate of return, which is its fixed total cost but is not able to produce a return in excess of its required return.
This also shows that the Marginal Revenue (MR) = Average Total Costs (ATC)
When a firm is operating at its Economic Break-Even Point (BEP), it still is sustainable in the long run; it just does not have any significant competitive advantages.
Abnormal Economic Profit
In this scenario, a firm will be earning an ROE way above its RRR.
For an abnormal profit scenario, all other factors are the same as the normal profit, but the Marginal Cost Curve is much higher than the ATC curve.
This suggests that the firm has high competitive advantages or moats, which allows the firm to achieve such high returns. This states that the firm can operate with good profitability in the long run
High ROEs attract competition as the industry itself is profitable, which allows other players to also enter the market. This eventually will make the eco-profit zero as more competition comes into the market, creating substitutes and diluting the market share.
There can be several reasons why a business earns an abnormal level of eco-profits.
Monopoly: There are further bifurcations in the types of monopoly
Natural Monopoly
Pure Monopoly
Regulated Monopoly
Superior Product
Untapped Market
Example 1:
A manufacturing unit currently makes a single product selling for $10 per unit. Its operating expenses come to around 4$ per unit. That makes the company 6$ of profit per unit with a 60% margin.
Now the store can diversify its product portfolio by adding one more product. The unit economics for the product comes down to $15 per unit with 11$ per unit of operating costs, making the company 4$ per unit.
Due to high capital requirements, the project is pushed ahead. Now, the eco-profit of the firm will be: $10 - $4 - $4 = $2.
So the eco-profit, after accounting for the $4 of profit forgone, will be $2 per unit.
Here the 6$ was the accounting profit for the firm. Even after accounting for the opportunity cost of 2$, the manufacturing unit will still be able to operate profitably in the long run.
Example 2:
| Total Revenue | $800,000 |
| COGS | $150,000 |
| SG&A | $350,000 |
| Implicit Cost | $100,000 |
Advantages and Limitations
There are certain limitations and benefits of every ratio as it cannot reflect every aspect of the business. The eco-profit is no different.
Even though it is very efficient for calculating the efficiency and quality of the business and also serves as an indicator to check management quality, it has its limitations. They are also very dynamic as the variables can be altered and adjusted to suit the type of business and the market situation as well.
For instance, as it is not an indicator of accounting profits, it can at times misrepresent the actual profitability. There also are some logistic limitations like estimations.
As eco-profits are a product of several different variables, the results can entirely depend upon the variables chosen to calculate, which are prone to bias and mathematical error.
Advantages
The advantages associated with it are
Excellent for Calculating Business Efficiency & Profitability
It is a great yardstick for measuring business efficiency. If a business can earn eco-profit, it means that it is able to earn sufficient levels of marginal revenue to continue its operation for a long time.
The business is also able to cover its required rate of return (RRR), which means it has an optimal capital structure set.
It is directly related to how efficiently a business can manage its operating expenses and how well it can estimate what is the right direction for the business to grow by selecting the best opportunities and keeping the opportunity cost to a minimum.
Serves as a good lagging indicator
A lagging indicator is something that can confirm a certain trend.
Eco-profit serves as a great lagging indicator because it can tell us if the management is making good decisions regarding the operating costs and opportunity costs.
We can look back on what opportunities the business has chosen and how they are fair alongside the rejected option. This can tell a lot about management efficiency as well.
This translates to a high Return on Equity (ROE); high ROE tells how good the management is at allocating equity capital and adding retained earnings.
Disadvantages
The disadvantages associated with it are
Estimation Difficulties
A major drawback is that it is difficult to estimate.
The variable that makes estimation difficult is the opportunity cost. There are a lot of logistic and accounting difficulties that can be faced while estimating the opportunity cost is very subjective to the business and the relevant scenario. Even if some opportunity cost is forgone, it does not necessarily mean it is bad.
A bad measure of profitability
Unlike accounting profit, economic profit is not a reliable measure of profitability due to its variability as they are based upon assumptions rather than accounting variables which makes the ratio unreliable.
The ratio glosses over or ignores a lot of important financial aspects that are actual measures of profitability.
It also depends a lot upon interest rates and the company's risk profile; if the rates go up, the cost of capital will go up.
Similarly, if the company's credit rating drops may be due to external or internal factors. Even if the margins are not affected, the cost of equity will go up, resulting in a higher cost of capital.
If the cost of capital goes up, the company needs to generate a high return on its capital to generate eco-profits.
Economic Profit Vs. Accounting Profit
Accounting profit is a measure of the accounting profitability of any company.
It is calculated by deducting explicit costs from the total revenue of a firm; explicit costs are normal operating expenses that are reported in a company's income statement.
One advantage of accounting profits is that it is very straightforward and easy to calculate. It is pre-calculated and audited by an independent auditor on the company's income statement. This makes it very reliable.
As accounting profit is the Revenue - Operating cost, it essentially is the pre-tax profit of a company.
Another advantage of accounting profit is that it can be compared with other companies with different tax regimes. As account profit ignores the tax effect, it makes the profits more comparable.
A drawback of accounting profit is that it makes no considerations for opportunities forgone.
Economic profit adds one variable to the accounting profit equation, which is the implicit costs.
These are costs that a business has forgone by taking up another available opportunity as it is more of a theoretical calculation by considering opportunities foregone.
For a business to be able to sustain itself in the long term, it is just not enough that it should cover its operating costs.
It should also be able to cover the required rate of return and deliver an ROE above its minimum cost of capital.
If a business is earning an economic profit, it shows that the business is sustainable in the long run and the marginal revenue (MR) is more than the average total cost (ATC), above its economic break-even point (BEP).
A drawback of eco-profits is that they are difficult to estimate as they are based on assumptions rather than data. External factors like interest rates and the risk profile of the company can have a considerable effect on the eco profits.
Economic Value Added (EVA)
Economic value added is nothing but the economic profit.
The most widely accepted calculation for a required rate of return is the weighted average cost of capital. So what EVA states are the difference between a firm's return on capital and cost of capital.
Economic value is added when a firm is returning in excess of its WACC
EVA is primarily used during project finance forecasting. EVA is used as a benchmark for whether the company should invest in a particular project or not. The higher the economic profits on a project better it is for a firm to invest in that project.
EVA can be used in place of free cash flow for estimating the absolute intrinsic value of a business.
A major drawback of free cash flow is that it cannot be used to value early-stage businesses with high Capex requirements, as free cash flow is the cash remaining after the capital and working capital requirements.
Please refer to Prof. Ashwath Damodaran's paper for further clarification on EVA
The formula for EVA is as follows:
EVA = (Return on capital - Cost of capital)(Capital invested in Projects)
The EVA formula has three variables to consider
Return on Capital (ROC)
Return on Capital is the percentage returns that the business has earned on the capital invested in the business over a financial year.
A business that has consistently shown a high return on capital is an indication of a business that has competitive advantages built around it.
There are a few variations of the ROC, but the most widely used are the ROCE & ROIC.
Return on Capital Employed (ROCE)
ROCE = EBIT/Capital Employed
Where,
EBIT = Earning Before Interest and Taxes
Capital Employed = Total Assets - Current Liabilities
Return on Invested Capital (ROIC)
ROIC = NOPAT/Invested Capital
Where,
NOPAT = EBIT*(1 - Tax Rate)
Invested Capital = Equity + Total Liabilities
ROCE or ROIC is used depending on the capital structure of the firm. ROIC is usually preferred as it takes into consideration the equity as well as the debt capital of the company.
ROCE is more focused on how efficiently the company is using the assets net of its working capital and other short-term obligations.
Cost of Capital
The cost of capital is the weighted average cost of the company's capital structure.
The company's cost of capital will entirely depend on its capital structures. If there is more debt on the books, then WACC will be preferred as it gives weightage to both its equity and debt capital. If the company operates on very low levels of debt or debt-free, then the cost of equity will be used as the cost of capital.
The cost of capital is used here as a minimum hurdle rate to earn economic profits. A business can only earn it once the returns on capital can not only cover the cost of capital but also earn significantly above the cost of capital.
The cost of capital is calculated by using the WACC
WACC = (Kd*Weight of Debt) + (Ke*Weight of Equity)
The Cost of Equity (Ke) is calculated using the capital asset pricing model (CAPM).
Where,
Rf is the Risk-free rate
B is the Beta of the company
E(Rm) is the expected Market returns
[E(Rm) - Rf] is called the Equity Risk Premium (ERP)
The cost of debt (Kd) is just the post-tax interest paid divided by the long-term debt of the firm.
Invested Capital
Invested Capital or Total Capital is the total debt and equity capital on the firm's balance sheet. Total Assets (TA) can also be considered as invested capital.
Invested capital = Equity + Long Term Debt
There are a few other ways to calculate invested capital as well. One other popular metric is the capital employed, where the working capital or current liabilities are subtracted from the total assets, depending on the type of business.
Capital employed is usually preferred for businesses that have low debt, but it does not consider the equity and current debt, so Invested capital is the most reliable metric.
Invested capital is the most reliable metric of capital as it takes both equity and debt capital into consideration, the same formula can be used to get the EVA of a particular project.
As it is a very dynamic metric, invested capital is usually used to calculate the EVA of a project or a firm.
Calculating the EVA
The data is pulled from the Annual Report of Advanced Micro Devices, Inc. (AMD)
ROIC
EBIT = Before Tax Profits + Interest Expenses
EBIT = 1275 + 47
EBIT = 1322
US corporate tax rate is 21%
NOPAT = EBIT * ( 1 - Tax Rate)
NOPAT = 1322 * (1 - 0.21)
NOPAT = 1044
Invested Capital = 8962
ROIC = 1044/8962
The Return on Invested Capital for Twitter is 12%
Cost of Capital
Cost of Debt
Kd = [Interest Exp / Long-term Debt * (1 - Tax Rate)]
Kd = (47 / 531) * (1 - 0.21)
Kd = 7%
Cost of Equity
Beta = 1.81
Rf = 2.8%
ERP = 4.2%
Ke = 2.8%+1.81*(4.2%)
Ke = 10.42%
WACC = (Kd*Weight of Debt) + (Ke*Weight of Equity)
WACC = (7% * 9%) + (10.42% * 91%)
WACC = 10.11%
The Enterprise Value Added for Advanced Micro Devices comes to.
EVA = (ROIC - WACC) * (Invested Capital)
EVA = (12% - 10.11%) * 8962
The economic value added for AMD in 2020 is $169 Million.
Everything You Need To Master Valuation Modeling
To Help You Thrive in the Most Prestigious Jobs on Wall Street.
or Want to Sign up with your social account?