What is Economic Profit, Economic Value Added and relation to valuation?

Replies to This Discussion

Permalink Reply by Pawan Jain on July 31, 2010 at 4:09am

Economic profit is the profit generated over and above what is expected (cost of capital).

If it is shown in absolute terms, then its the profit number. If it is shown in % terms, then it is x% above your expected returns (cost of capital).

Suppose you manage a business where you are expected to earn 100 on an investment of 1000 in a year. You end up earning 120. 20 is the economic profit (2% in % terms). Higher the EVA/EP, better the quality of management (assumed to be achieved by optimum utlization of resources or getting more bang for the buck).

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Permalink Reply by Raja Dawn on August 4, 2010 at 9:00am

There is a difference in what you are "expected to earn" and your "cost of capital". Cost of capital is strictly the cost of debt plus the cost of equity. The cost of Debt is pretty straight forward - the interest cost which you pay annually on the debt. The cost of equity is where the 'expectation' theory nudges in. CAPM provides you the cost of equity as "risk free rate + risk premium" which is 'expected' to be earned from investing in a business as a equity holder. Thus in the above example 100 must be equal to partly interest cost and partly expected earning on equity.

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Permalink Reply by Sachidanand (Sacha) Singh on July 31, 2010 at 5:02am

1) a) EVA and EP are the same thing:EVA = EP = NOPAT - Cost of capital*Capital employed
b) 5% EP means the firm has earned on its capital employed 5% more than the cost of its capital employed; i.e. (NOPAT/Capital employed) - Cost of capital = 5% . $100 EP mean NOPAT - Cost of capital*Capital employed = 100

2) Since DCF valuation discounts cash flows with cost of capital employed, the two approaches to valuation i.e. EVA and DCF, will give the same value. You can refer to any good text on valuation (McKinsey's and Damodaran for example) to see the underlying identity of the two approaches. Prof Damodaran has a paper / some other material on his website explaining the essential identity of the two approaches in a very lucid manner. Do visit.

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Permalink Reply by Vijay on August 1, 2010 at 1:45pm

EP and EVA are the same and can be expressed as an absolute no as well as % (say of revenue). Basically, it shows the returns over cost of capital. I am attaching a file which I got from a finance website and explains in detail the concept.

DCF is the sum of present value of cash flows and equals the sum of future EP over years and the current invested capital of the company. The DCF method based on future cash flows and the EP methodology should match up.

Attachments:

• Ashok Leyland_Auto_EP Tree (2).xls, 157 KB
• Methodology - EP Tree[1].pdf, 44 KB

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Permalink Reply by Vikram Kumar on August 2, 2010 at 12:47am

Thankyou all.

Mr Singh - your reply is much appreciated. I went through the mckinsey book and did find the relation between EP and the normal DCF.

Also found a link in case other readers are interested
http://www.ktu.lt/lt/mokslas/zurnalai/ekovad/14/1822-6515-2009-709.pdf

Mr Vijay - thanx a lot for the attachments, it was quite a detailed document on EP. Where is this file sourced from? What other valuation related information is available here, because the excel format seems its a database giving this information?

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Permalink Reply by Henry T on August 2, 2010 at 12:26pm

Hi all,

just want to add my 2 cent's worth. Just a quick intro about myself, I used to work at a consultancy firm (not McKinsey but boutique enough) so it's our main tool for measuring and managing corporate goals/performance, including of course valuation.

Economic Profit or EP is indeed the profit earned over and above the cost of capital, it can be expressed in two versions -- the WACC version or the COE (cost of equity) version. Of course, if use WACC version, you need to use NOPAT (which is earnings after tax but with interest added back); for COE version, you just take Net Income.

EVA or Economic Value-added, although is based on the same principle (profit less capital charge), is slight more complex. Invented by Stern Steward, another consultancy firm, it requires over 100 adjustments to define "earnings', since it primarily started off as a measure that corporate business units need to be able to measure and in some cases, used as input to incentivise managers.

Of course these days, the two are used interchangeably. The intent why it was used so extensively in corporates or business units is because of its simplicity -- that any profit generated in any business requires a charge for capital investment, and this can be use to even set corporate-level goals, e.g. 5-year goal. This discussion will become a book if i carry on...

1) Now the % and absolute version is correctly explained per previous discussions -- the higher the better, full stop.

2) As for how it ties up to DCF or valuation. It is essentially another version of DCF. If you start with the book (shareholder equity) and EP calculated using COE version, you create a stream of EPs over the period so present value these EP streams will become your value creation over and above your book, if you add back the book to this value creation, this gives you equity value of the firm! If you use the WACC version, i.e. capital = equity + debt, then the streams of EP (based on WACC) present valued + initial capital = firm value, subtract the debt will give you equity value of the firm. Very much like FCFE and FCFF valuation. Both methods should give you identical equity values, and they should tally up with FCFE/FCFF methods.

Caveats: Note that for EP to work in valuation using both WACC or COE methods, the financial statements must obey the clean surplus accounting rule, i.e. shareholder equity changes must flow from income statement. So any changes in comprehensive income within shareholder equity without reflecting on income station will ruin this EP valuation method.

Hope this helps!

Useful link to the different economic profit-based measures: http://books.google.co.uk/books?id=o_W8SgcU-ysC&pg=PA8&lpg=...

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Permalink Reply by Vikram Kumar on August 3, 2010 at 12:28am

Hi Henry,

Thanx for the reply.

Now if I understand correctly the EVA or EP is also used as a performance benchmarking measure. In this case when we calculate EP using debt + capital approach; the EP is NOPAT less WACC (total capital).
a) Will the total capital include fixed assets as well as intangible assets?
b) Will the intangible assets also include goodwill?
c) The reason I ask for goodwill is that now days particularly in India companies make acquisitions at exorbitant premiums and hence have large goodwill in the balance sheet. Capital charge might be higher leading to lower or negative EP. However this necessarily does not mean the company is performing bad. Its only a strategic decision whose impact will be seen in the longer term. However if shareholders decide to award the CEO based on EP he might be penalized for doing the M&A.
d) However when I am buying the company I will also consider the goodwill on its balance sheet.

I am confused whether to include the goodwill or exclude it?

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Permalink Reply by Sachidanand (Sacha) Singh on August 3, 2010 at 12:41am

As an investor would you or would you not demand return on the capital blocked in goodwill?

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Permalink Reply by Vikram Kumar on August 3, 2010 at 1:12am

a) As an investor I will want return on anything I invest in and I agree to that point.

b) However to evaluate the performance of a CEO whose salary is linked to annual profits, the long term strategic decision he has taken is penalizing him in the short term as the EP is negative or too less in the current year.

This is exactly where I have the confusion, from a valuation perspective I will include goodwill as valuation involves long term assumptions. But some thing like evaluating annual performance is short term so should I include goodwill?

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Permalink Reply by Vijay on August 3, 2010 at 1:37am

Valuation based on DCF should exclude goodwill unless you explicitly know how much premium the company is expected to pay in future for specific transactions. Reasons are the effect of goodwill is already factored in the profit figures being generated. EP can be calculated including or excluding goodwill.

Including Goodwill shows the actual returns to stakeholders including the premium paid. For comparing operating performance, EP excluding GW works well and should be used for short term performance linked bonus for example

Regarding the source of the files, I got those from a website-Finsights.in. The website has a database of ~80 Indian companies and provide financial information in excel such as EP, ROCE, Multiples, etc.

Here's the link (http://finsights.in/Web/Home)

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Permalink Reply by Vijay on August 4, 2010 at 3:02am

Agree. But I see two scenarios now-evaluating the performance for an acquisition made-something not doable effectively in the short term-so what do we do-ignore the short term performance?

I would rather use ep without goodwill but keep in mind the long term effect of acquisition is yet to be factored in accurately.

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Permalink Reply by Vijay on August 6, 2010 at 12:51pm

I found this useful website which has a lot of useful info.Like all wiki resources this is detailed and transparent. One can also download all the information including the model in MS excel.

http://www.wikiwealth.com/

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