Economic profit is a RAPM that is widely employed for assessing a firm’s financial performance. It is also known by the trademarked name economic value added (EVA). The concept is that a firm only adds value for its shareholders if it makes a profit in excess of what could have been earned if its capital were invested in some other, similarly risk venture. The basic formula is
economic profit = NOPAT – opportunity cost of capital
where NOPAT denotes net operating profit after taxes. A positive economic profit indicates that a firm has added value for shareholders. Implementations of this basic formula vary, both in how they define NOPAT and in how they define the opportunity cost of capital.
NOPAT is an accounting concept. Firms report it in their financial statements. Some implementations of economic profit simply use reported NOPAT. Others modify NOPAT to make it, in some sense, more economically meaningful. Various modifications are used in practice, with the choice depending on the nature of a firm’s business as well as the inevitable tradeoff between economic significance and simplicity. Generally, modifications are designed to subtract non-cash earnings from reported NOPAT. Examples include:
- subtracting earnings due to the amortization of goodwill,
- deducting extraordinary gains or losses that result from changes in accounting practices,
- immediately recognizing, instead of accruing, losses from non-performing loans.
The opportunity cost of capital should reflect the expected return on capital obtainable from other, similarly risky ventures. This is not an accounting notion, and there is considerable leeway in how to assign it a value. One issue is how to define a firm’s capital. Usually, economic capital is used, but there is flexibility in how this is defined. Another issue is determining what might be the expected return on comparable investments. One standard approach is to employ the capital asset pricing model. The expected return on capital is then calculated using the beta of the firm’s stock price.