Economic profit approach

Accounting profit charges a company for its borrowings and nothing for its shareholders' money. Yet shareholders want a return too.

Economic profit is what is left after every provider of capital has been paid the return it requires. A business that earns less than the cost of its capital has negative economic profit — even when its profit and loss account shows a profit.

The economic profit approach turns that idea into a valuation. It says the value of a business is two things added together:

1. the capital presently employed in it; and
2. the present value of the economic profit it is projected to earn in future.

Read it plainly. The money already in the business is worth what is in it. Anything on top is worth having only if the business can earn more than the required return. That extra is the second term.

So a company with a fat profit and no margin over its cost of capital is worth the capital in it, and no more.

The workbook's definition (Chapter 11, section 11.4). The business valuation chart gives economic profit a column of its own. It uses the economic profit of a company in a given period and measures the value of the company; under this approach, value is defined as the sum of the present capital employed and the present value of the projected economic profit for the future.

Where it sits among the five approaches.

And then the sentence that gets examined. The approaches mainly used are the earnings approach based on DCF analysis (the income approach), relative valuation based on earnings multiples (the market approach), and the asset based approach (the cost approach). The economic profit approach is on the chart but not in that trio.

What the workbook does not give. Section 11.4 supplies no formula, no illustration and no figure for this approach. It does not define capital employed, does not give a rate at which to charge capital, and works no example. That absence is worth knowing: anything more precise than the definition above has come from outside XIX-D.

What the approach needs, and where the workbook happens to compute it. An economic profit calculation needs a required return on capital. Chapter 11 derives one — but for the DCF method. Box 11.1 takes a pre-tax cost of long-term debt of 12.5% and a tax rate of 30%, giving a post-tax cost of debt of 8.75%; a cost of equity of 17.5% from CAPM adjusted for any specific risk premium; and a debt-equity ratio of 1.5:1, so debt is 1.5 ÷ 2.5 = 60% of the capital structure and equity 40%. The WACC is (8.75 × 60%) + (17.5 × 40%) = 5.25% + 7% = 12.25%. The workbook never applies that WACC to the economic profit approach. Borrow it only as an assumption, and label it as one.

The one connection the workbook does make. Section 11.4.1 is placed deliberately before any methodology, because the difference between enterprise value and equity value has to be understood first: EV = equity value (market cap) + total debt net of cash + preference capital, if any. Illustration 11.3 works it — a market cap of INR 1,000 crore, long-term debt of INR 200 crore, preference capital of INR 50 crore and cash of INR 5 crore give 1,000 + (200 − 5) + 50 = INR 1,245 crore. What the workbook does not say is whether the economic profit approach produces enterprise value or equity value. Do not assume either.

Value of the business = Capital presently employed + Present value of projected future economic profit

where, for any year, Economic profit = Net operating profit after tax − (Capital employed × Cost of capital)

Illustrative. Section 11.4 gives no worked example and no figure for this approach, so every number below is an assumption. The 12.25% capital charge is the WACC the workbook itself computes in Box 11.1 for the DCF method, borrowed here only to make the arithmetic run.

Vidarbha Castings Pvt Ltd is a Category II AIF portfolio company with Rs 400 crore of capital employed. The capital charge is Rs 400 crore × 12.25% = Rs 49 crore a year.

On the workbook's definition:

Value = present capital employed + PV of projected economic profit = Rs 400.0 crore + Rs 96.2 crore = Rs 496.2 crore.

What the split tells an investment committee. Rs 400 crore of that value is simply the money already in the business. Only Rs 96.2 crore — about 19% — comes from the business earning more than its capital costs. A fund paying much above Rs 496 crore is paying for economic profit nobody has forecast.

Now make the business ordinary. Suppose NOPAT is flat at Rs 49 crore a year instead. The capital charge is also Rs 49 crore, so economic profit is nil in every year and the value collapses to the capital employed: Rs 400 crore. The company is still profitable — Rs 49 crore of NOPAT every year — and worth no more than the money put into it.

And make it worse. At NOPAT of Rs 40 crore a year the economic profit is minus Rs 9 crore a year. Discounted over five years at 12.25% that is about minus Rs 32 crore, so the value falls to roughly Rs 368 crore — below the capital employed. A positive accounting profit, and value destroyed.

Chapter 11, section 11.4 (Approaches to Business Valuation). Because the approach appears only in the chart there, it is a definition question rather than a calculation question.

Expect the direct form — under which approach is value defined as the sum of the present capital employed and the present value of the projected economic profit for the future — and the negative form, which is the more common trap: the workbook says the approaches mainly used are the income or DCF approach, relative valuation and the asset based approach, so the economic profit approach and contingent claim valuation are the two on the chart that are not in that list. Section 11.4.1 on enterprise value against equity value, and Box 11.1 with its WACC of 12.25%, sit in the same stretch of the chapter and are examined in their own right.

• This is a valuation approach; economic value added is a period measure. EVA asks whether value was created over a past period. This approach adds the capital employed to the present value of the future economic profit stream in order to price the whole business. They share one idea, and XIX-D's chart names only the approach.
• Capital employed goes in at its present amount and is not discounted. Only the future economic profit stream is discounted. The workbook's words are the sum of the present capital employed and the present value of the projected economic profit.
• Nil economic profit does not mean nil value. It means the business is worth the capital in it and nothing more.
• It is not in the income or earnings family in the workbook's chart, and it is not one of the three mainly used approaches. Both points get set as questions.
• XIX-D gives no figure for this approach. Any rate, definition of capital employed or worked number comes from outside this workbook. If an option offers a rate, check it is not Box 11.1's DCF WACC being quietly reused.
• Not the earnings capitalisation of earnings method either. That is the income family's alternative to DCF, and the workbook calls DCF the more comprehensive of the two.
• The workbook does not say whether the answer is enterprise value or equity value. Section 11.4.1's EV-to-equity relationship is stated for the methodologies generally, not for this approach specifically.