Equity Valuation: Models from Leading Investment Banks

12

From Accounting to Economics: Economic Profit

12.1 THE BASICS

Unlike CFROI, which calculates a return on investment via an IRR calculation, EP measures the absolute amount of wealth creation in a given year. EP is the residual profit left after subtracting a capital charge from the net operating profit after tax (NOPAT). The capital charge is made on the capital employed by the firm bearing in mind that both debt and equity investors demand a return on their investment.¹

The first step in calculating EP is to calculate NOPAT (net operating profit after tax):

Revenue

− Cost of goods sold (COGS) − Selling, general and administrative costs (SG&A) − Depreciation

+ Other operating income

= EBIT (earnings before interest and taxes)

* (1 – Cash tax rate)

= NOPAT

The next step is to calculate the cost of capital, based on the firm's capital structure. In its simplest guise (without considering accounting adjustments), the invested capital used in calculating the capital charge is:

Fixed assets

+ Current assets − Current liabilities

= Invested capital

The calculation of invested capital is often based on the average capital to reflect the fact that NOPAT is earned during the course of the year, while the balance sheet reflects a point in time. For valuation purposes (discussed in more detail below), the opening invested capital is used for the capital charge.

Since NOPAT is the operating profit to the firm's capital providers, a weighted average cost of capital (WACC) based on the relative ...