What is Economic Profit?

Economic Profit measures the overall profitability of a business after considering all costs incurred to obtain revenue.  Economic profit measures a business’ true profitability by accounting for total opportunity costs. Unlike accounting profit, which only considers explicit costs like wages and rent, economic profit includes both explicit and implicit costs. Implicit costs reflect the opportunity costs of capital and other resources, offering a more comprehensive assessment of whether value is being created or destroyed.  This metric indicates how well a firm invests its resources and whether it is outearning competitors. Analysts can use Economic Profit to determine if a business should enter or exit a market or an industry.

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$$\text{Economic Profit}=(\text{ROIC}-\text{WACC})\times \text{Invested Capital}$$

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Return on Invested Capital

ROIC is a metric used to evaluate the efficiency of a company’s capital deployment. It measures profitability relative to the amount of capital invested by shareholders and debtholders. To calculate ROIC, we consider a company’s NOPAT - their net performance after taxes but before interest payments. NOPAT is then divided by equity, debt, and capital leases. Analysts typically prefer the book value of a company’s investments over market value because the market value may be inflated due to future expectations, a perceived earning value of a company not always in line with reality. Companies with an ROIC consistently above its cost of capital (WACC) tend to allocate capital to profitable projects and position themselves for long-term growth and market share.

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$$\text{ROIC}=\frac{\text{NOPAT}}{\text{Invested Capital}}=\frac{\text{EBIT}\times (1-\text{Tax Rate})}{\text{Invested Capital}}$$

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Weighted Average Cost of Capital

WACC is the average interest rate at which a company can obtain financing through debt or equity. Sources of financing can include common stock, preferred stock, bonds, and other forms of debt. The WACC calculation considers the amount (weight) of equity and debt a company has.

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$$\text{WACC}=(\text{Cost of Debt}\times \frac{\text{Debt}}{\text{Total Capital}})+(\text{Cost of Equity}\times \frac{\text{Equity}}{\text{Total Capital}}\times (1-t))$$

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Calculating Economic Profit

To calculate Economic Profit, we consider the net return on invested capital, cost of capital to generate the return, and the amount invested. For example, in 2024, Company A generated $100 million in operating income (EBIT), with a tax rate of 20.0%. Company A’s balance sheet reports an average of $300 million in fixed assets and net working capital across 2023 and 2024. The company has a WACC of 10%.

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The calculation of Company A’s economic profit for 2024 is as follows:

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NOPAT:

20.0% × $100 million (EBIT multiplied by the corporate tax rate) = $20 million

$100 million - $20 million (EBIT minus the tax amount) = $80 million

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ROIC:

$80 million ÷ $300 million (NOPAT divided by the investment amount) = 27%

minus WACC (27% - 10.0%) = 17%

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Economic Profit:

17% × $300 million (multiply by the invested capital) = $51 million