Notes On Economic Profit

Economic Profit is a measure that combines ROIC and size into a currency metric (such as the U.S. dollar). You can use Economic Profit as another way to measure a company's value creation. Specifically, Economic Profit measures the value created by a company in a single period of time. The formula for economic profit is:

Economic Profit = Invested Capital x (ROIC - Cost of Capital)

To be precise, Economic Profit is the spread between the ROIC and cost of capital times the amount of invested capital. 

Another way a company can be valued is by discounting its projected Economic Profit at the cost of capital and adding the starting invested capital. In terms of a formula that would look something like this:

Value = Starting Invested Capital + PV(Projected Economic Profit) 

Note: Economic Profit is also a robust tool for comparing the value creation of different companies. 

Nutshell Summary: Using Economic Growth for measuring performance encourages companies to undertake investments that earn more than their cost of capital, even if their return is lower than the current average return. It sounds simple and intuitive, but sometimes managers need a scorecard (or multiple) to look at to make sure they're making the right decisions for the long term. Economic Profit can serve as one of those scoreboards.