Pages: 28 (8421 words) Published: October 1, 2010
Examining the components of economic profit and studying the finer points of its calculation require an understanding of its underlying principles. Here we look at how it matters as a performance measure - which is distinct from a wealth metric - and how it is closely related to market value added (MVA). Finally, in establishing an overall picture of economic profit, we help you undo any perceived complexity by showing how all of the calculations surrounding economic profit originate from three main ideas.

Economic Profit Is a Performance Metric
To understand economic profit, it helps to distinguish between a performance metric and a wealth metric. A performance metric refers to a measure under company control, such as earnings or return on capital. A wealth metric, on the other hand, is a measure of value that - such as equity market capitalization or the price-to-earnings (P/E) multiple -depends on the stock market's collective and forward-looking view. Now, although these two types of metrics are distinct, they are related.

Every performance metric has a corresponding wealth metric. In theory, over the long run, a performance metric can be expected to impact its corresponding wealth metric. For example, consider the matching pair of earnings per share (EPS), a fundamental performance metric, and the P/E multiple, its corresponding wealth metric. The variables that determine EPS - earnings and shares outstanding - are numbers affected only by the company's actions and decisions. On the other hand, the P/E multiple, which is determined by the company's stock price, depends on the value of these actions and decisions assigned by the stock market. The company therefore influences the P/E ratio but cannot fully control it. Here is another way to think about the difference between the two: EPS is a current (or historical) fact but P/E is a forward-looking and collective opinion.

The key criterion for the pairing of a performance and wealth metric is consistency: each half of the pair should reference the same group of capital holders and their respective claims' on company assets. For example, EPS by definition concerns the allocation of earnings to common shareholders; the P/E multiple refers to equity market capitalization, which is the value held by shareholders.

Consider another example: return on capital (ROC) is a performance metric that represents the return both to debt and stockholders, and its corresponding wealth metric is the EBITDA multiple - the value of total debt, plus equity market capitalization (also known as the "enterprise value" or "entity value"), divided by earnings before interest, taxes, depreciation and amortization (EBITDA). This is also called the "price-to-EBIDTA multiple", or "the enterprise multiple". Note how ROC and the EBITDA multiple meet the consistency test. Like  ROC, EBITDA captures earnings that accrue to both holders of stock and debt. The EBITDA multiple, therefore, reveals how the market values the company in light of earnings to stockholders and debt-holders.

Below is a chart listing a few performance metrics and their corresponding wealth metrics. Note that economic profit's corresponding wealth metric is market value added (MVA). We explore this relationship below as we come to understand specifically what economic value is and how works:

|Performance metric |Wealth metric | |Return on Equity (ROE), EPS growth |P/E Ratio | |Return on Capital (ROC or ROIC), Operating Income |Ratio of: Entity value ÷ EBITDA | |Growth | | |Economic Profit |Market Value Added (MVA) | |Free Cash Flow |Equity Market Capitalization...