What is economic profit and how does it differ from accounting profit for measuring value creation?

Economic profit is one of the most important concepts in corporate finance because it answers a question that accounting profit ignores: is the company earning more than its cost of capital?

The Key Difference

Accounting Profit = Revenue - Expenses (including interest on debt)

• Ignores the cost of equity capital
• A firm can show positive net income while destroying shareholder value

Economic Profit = NOPAT - (WACC x Invested Capital)

• Charges for ALL capital, including equity
• Positive economic profit means the firm is creating value above its required return

Where:

• NOPAT = Net Operating Profit After Tax
• WACC = Weighted Average Cost of Capital
• Invested Capital = Total debt + equity deployed in operations

Why Accounting Profit Misleads

Consider two divisions of Pemberton Industries:

By accounting profit: Both divisions are profitable. Zenith earns $9M!

By economic profit: Zenith is destroying value. Its $9M return is less than the $10M investors require for the $100M of capital employed. Shareholders would be better off if that $100M were invested elsewhere.

Economic Value Added (EVA)

EVA is the trademarked version of economic profit, calculated the same way:

EVA = NOPAT - (WACC x Invested Capital)

Companies that consistently generate positive EVA create shareholder value; those with negative EVA destroy it.

Connection to MVA

Market Value Added = Market Value of Firm - Invested Capital

MVA is the market's assessment of all future EVA. A firm trading above its invested capital base has positive MVA, implying the market expects positive future economic profits.

Exam tip: CFA Level I often tests whether you can identify value creation vs destruction using economic profit. A firm with positive accounting profit but negative economic profit is destroying value. Always compare return on invested capital to WACC.

Practice more in our CFA corporate finance question bank.