“The point of economic profit is for the both the company and the shareholder to make money in the context that both have choices in capital allocation. If a corporation and shareholders can make sufficient returns – measured against other investment options and risk – then management has met its ultimate responsibility”.
- Wilhelm Reinhardt
In 1981, the Business Roundtable issued its “Statement on Corporate Responsibility”[1] in which they stated, “Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment to continue and enhance the enterprise, provide jobs, and build the economy. The long-term viability of the corporation depends upon its responsibility to the society of which it is a part. And the well-being of society depends upon profitable and responsible business enterprises.” This thinking reached its apex in the decades following World War II and was best captured in Charles Wilson’s (General Motors CEO) statement to Congress that “what was good for our country was good for General Motors and vice versa.” It's only in the past 25 years that the focus has shifted dramatically from that of a corporation’s social responsibility and accounting profits to that of providing economic profits to its shareholders. Indeed – in 2013 - Ralph Gomory & Richard Sylla[2] went on to entirely contradict Wilson by stating, “We cannot, therefore, ignore the possibility that the interests of our (global) corporations and the interests of our country may have diverged.”
One of the major drivers in this change has been the movement of stressing not only accounting profits but measuring economic profits as well. This hasn’t been just in corporate management. Savvy institutional investors are also adding this to their quiver of value calculation.
Accounting profit is generated by using Generally Accepted Accounting Standards (GAAP) in which expenses and costs are subtracted from revenue. It includes the direct costs of conducting business, such as all operating expenses, interest, taxes, and depreciation. Economic profit is the same as accounting profit except opportunity costs are included in the calculation. My definition has a slight twist that doesn’t appear in most economic profit calculations. I utilize two key measures to calculate whether a company is creating economic profits. The first is that return on invested capital (ROIC) must be greater than weighted average cost of capital (WACC). This tells you whether the company has historically generated economic profits. The second is that earnings must not only exceed accounting costs but also opportunity costs. It’s important to point out that a potential investment can have a significant accounting profit but no economic profit.
A Working Example
As an example of this, let’s use Acme Rubber Band company as an example. The company has traditionally been in the office supply business with two core industry segments – healthcare and automotive. Both industry focuses have developed over the past 30 years in business. In the past year on revenue of $100 million the company has a net profit of $20 million dollars. This is their accounting profit. But let’s assume the company has the opportunity to purchase a smaller supplier - Bobo’s Rubber Bands - that focuses on the technology sector. Step one is to ascertain whether Acme’s return on invested capital is greater than its weighted average cost of capital. This can be found in Gurufocus’ 30-year corporate financial data. Under ratios, simply subtract WACC from ROIC. If this number is greater than 15% I’m interested. Second, you have to ascertain the economic profit derived from allocating or not allocating capital towards an acquisition of Bobo. Bobo’s does $25 million in business and generates $5 million in net profit. Acme decides to pass on the acquisition believing it should focus on its core markets. Acme’s economic profit would be its accounting profit ($20 million) less Bobo’s potential/opportunity profit of $5 million. Thus, Acme’s economic profit would be $15 million. After modeling this, a potential investor can see in general whether a company has a tradition of generating economic profits and what opportunities may lie ahead to improve them.
On paper this process sounds like a relatively easy concept. But in reality, it is an extraordinarily difficult task to complete as you begin to investigate a potential investment. Ascertaining whether a company has historically generated accounting profits is the easy part (revenue less costs essentially). Modeling potential future economic profits requires a great deal of company and industry expertise as well as understanding the financial and profitability of new opportunities. The ability to identify, quantify, and allocate capital in the context of economic profits is an intense process. Someone like Warren Buffett can complete such an analysis in a matter of seconds while most mortals like us require far more effort.
Why This Matters
This may seem like a rather esoteric discussion in which an investor might quickly peruse and move on. But the difference between accounting profits and economic profits can be potentially huge for the long-term value investor. High accounting returns don’t always guarantee high investment returns. If a company generates significant accounting profits but produces no economic returns, investors may see very little long-term value generation through stock price appreciation. Companies that have been the largest gainers over my investing career have been those that generate great accounting and economic profits. Outstanding managers will keep an eagle eye on economic profits equally – if not more – than his/her accounting profits.
I’ve learned that mastering economic profit calculation can take an extra intellectual elbow grease, but is worth the effort in the long run. It requires you to know nearly everything about the company and how it generates an accounting profit or loss. On top of that, it forces you to think as an owner trying to calculate the best means in allocating capital. Any way to widen the gap (in a positive way!) between ROIC and WACC can potentially increase investment return over the long term.
I will generally try to engage management in a discussion related to economic profits. Great managers intuitively understand you are asking about their methods of allocating capital, weighing the cost/benefit of potential new ventures or acquisitions, and how these choices impact long-term growth strategies. Anybody who doesn’t understand the difference between accounting and economic profits is simply not worth partnering with in my view.
Conclusions
Economic profit isn’t a subject matter covered very much in investment books. That’s a shame. The idea that making astute capital allocation choices produces significant value over the long-term is a vital concept to understanding the future potential of your investment. Much like getting your discount rate wrong in a discounted free cash flow model, not understanding your investment’s economic profit can really skew your valuation estimates. What’s interesting is we calculate economic profit in our head all the time – if I go to grad school and have to take two years off is it worth it? If I purchase this 56” wide screen TV, will I need to sleep on the couch for the next 6 months? Making it part of your investment valuation process may not generate an accounting profit for you, but it just might just juice your economic profits.
[1] The Business Roundtable, “Statement on Corporate Responsibility,” October 1981. This view changed dramatically so that by 1997 the statement was revised to read, “The principal objective of a business enterprise is to generate economic returns to its owners. If the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value.”
[2] Ralph Gomory & Richard Sylla , “The American Corporation”, Dædalus, the Journal of the American Academy of Arts & Sciences, 2013
- Wilhelm Reinhardt
In 1981, the Business Roundtable issued its “Statement on Corporate Responsibility”[1] in which they stated, “Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment to continue and enhance the enterprise, provide jobs, and build the economy. The long-term viability of the corporation depends upon its responsibility to the society of which it is a part. And the well-being of society depends upon profitable and responsible business enterprises.” This thinking reached its apex in the decades following World War II and was best captured in Charles Wilson’s (General Motors CEO) statement to Congress that “what was good for our country was good for General Motors and vice versa.” It's only in the past 25 years that the focus has shifted dramatically from that of a corporation’s social responsibility and accounting profits to that of providing economic profits to its shareholders. Indeed – in 2013 - Ralph Gomory & Richard Sylla[2] went on to entirely contradict Wilson by stating, “We cannot, therefore, ignore the possibility that the interests of our (global) corporations and the interests of our country may have diverged.”
One of the major drivers in this change has been the movement of stressing not only accounting profits but measuring economic profits as well. This hasn’t been just in corporate management. Savvy institutional investors are also adding this to their quiver of value calculation.
Accounting profit is generated by using Generally Accepted Accounting Standards (GAAP) in which expenses and costs are subtracted from revenue. It includes the direct costs of conducting business, such as all operating expenses, interest, taxes, and depreciation. Economic profit is the same as accounting profit except opportunity costs are included in the calculation. My definition has a slight twist that doesn’t appear in most economic profit calculations. I utilize two key measures to calculate whether a company is creating economic profits. The first is that return on invested capital (ROIC) must be greater than weighted average cost of capital (WACC). This tells you whether the company has historically generated economic profits. The second is that earnings must not only exceed accounting costs but also opportunity costs. It’s important to point out that a potential investment can have a significant accounting profit but no economic profit.
A Working Example
As an example of this, let’s use Acme Rubber Band company as an example. The company has traditionally been in the office supply business with two core industry segments – healthcare and automotive. Both industry focuses have developed over the past 30 years in business. In the past year on revenue of $100 million the company has a net profit of $20 million dollars. This is their accounting profit. But let’s assume the company has the opportunity to purchase a smaller supplier - Bobo’s Rubber Bands - that focuses on the technology sector. Step one is to ascertain whether Acme’s return on invested capital is greater than its weighted average cost of capital. This can be found in Gurufocus’ 30-year corporate financial data. Under ratios, simply subtract WACC from ROIC. If this number is greater than 15% I’m interested. Second, you have to ascertain the economic profit derived from allocating or not allocating capital towards an acquisition of Bobo. Bobo’s does $25 million in business and generates $5 million in net profit. Acme decides to pass on the acquisition believing it should focus on its core markets. Acme’s economic profit would be its accounting profit ($20 million) less Bobo’s potential/opportunity profit of $5 million. Thus, Acme’s economic profit would be $15 million. After modeling this, a potential investor can see in general whether a company has a tradition of generating economic profits and what opportunities may lie ahead to improve them.
On paper this process sounds like a relatively easy concept. But in reality, it is an extraordinarily difficult task to complete as you begin to investigate a potential investment. Ascertaining whether a company has historically generated accounting profits is the easy part (revenue less costs essentially). Modeling potential future economic profits requires a great deal of company and industry expertise as well as understanding the financial and profitability of new opportunities. The ability to identify, quantify, and allocate capital in the context of economic profits is an intense process. Someone like Warren Buffett can complete such an analysis in a matter of seconds while most mortals like us require far more effort.
Why This Matters
This may seem like a rather esoteric discussion in which an investor might quickly peruse and move on. But the difference between accounting profits and economic profits can be potentially huge for the long-term value investor. High accounting returns don’t always guarantee high investment returns. If a company generates significant accounting profits but produces no economic returns, investors may see very little long-term value generation through stock price appreciation. Companies that have been the largest gainers over my investing career have been those that generate great accounting and economic profits. Outstanding managers will keep an eagle eye on economic profits equally – if not more – than his/her accounting profits.
I’ve learned that mastering economic profit calculation can take an extra intellectual elbow grease, but is worth the effort in the long run. It requires you to know nearly everything about the company and how it generates an accounting profit or loss. On top of that, it forces you to think as an owner trying to calculate the best means in allocating capital. Any way to widen the gap (in a positive way!) between ROIC and WACC can potentially increase investment return over the long term.
I will generally try to engage management in a discussion related to economic profits. Great managers intuitively understand you are asking about their methods of allocating capital, weighing the cost/benefit of potential new ventures or acquisitions, and how these choices impact long-term growth strategies. Anybody who doesn’t understand the difference between accounting and economic profits is simply not worth partnering with in my view.
Conclusions
Economic profit isn’t a subject matter covered very much in investment books. That’s a shame. The idea that making astute capital allocation choices produces significant value over the long-term is a vital concept to understanding the future potential of your investment. Much like getting your discount rate wrong in a discounted free cash flow model, not understanding your investment’s economic profit can really skew your valuation estimates. What’s interesting is we calculate economic profit in our head all the time – if I go to grad school and have to take two years off is it worth it? If I purchase this 56” wide screen TV, will I need to sleep on the couch for the next 6 months? Making it part of your investment valuation process may not generate an accounting profit for you, but it just might just juice your economic profits.
[1] The Business Roundtable, “Statement on Corporate Responsibility,” October 1981. This view changed dramatically so that by 1997 the statement was revised to read, “The principal objective of a business enterprise is to generate economic returns to its owners. If the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value.”
[2] Ralph Gomory & Richard Sylla , “The American Corporation”, Dædalus, the Journal of the American Academy of Arts & Sciences, 2013
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