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many of the distortions of ROIC and improve inter-company comparability. Even when ROIC makes sense, economic profit should be employed as another measure to evaluate the firm. Economic profit could also be related to other firm factors, such as total employees or units sold. Doing so would provide the analyst with comparability measures specific to a particular industry or situation. When used in this way, economic profit can indicate management ability to create value relative to its peer group or the direction and efficiency of its spending. For example, a pharmaceutical company analyst may wish to look at the economic profit per researcher. Economic profit is defined as a companys free cash flow exclusive of interest income minus a capital charge, with the charge calculated as the companys weighted average cost of capital multiplied by the operating invested capital. The traditional definition of economic profit utilizes after-tax operating profits in lieu of free cash flow. Example Calculating the 2008 Economic Profit for 3M (MMM) using the following financials:
From the free cash flow, interest income is subtracted since we are computing the economic return on the invested capital, not the total free cash flows, which include the returns on the financial assets as well. MMMs economic profit was $ 2.2 bn. during 2008 When we compare MMMs economic profit to its 2008 revenues of $ 25,269 mil, we arrive at 8.9%, which could then be compared to its historic results or to other companies in its industry. The economic profit could also be related to employee headcount or other useful factors important to the company. Example: This is how Clorox (CLX) computed its economic profit for fiscal years 2007-2009. As seen, it utilized a partial cash flow format by excluding some non-cash charges.
Source: Clorox Corp 2009 10K Clorox could have taken its definition a step further, as we did with MMM, by substituting free cash flow for operating profit, since operating profits are subject to GAAP and we are gauging cash return, to compare the result to revenues or other useful measures, including invested capital. We believe CT Capitals definition of free cash flow and capital employed to be more reflective of invested capital than is Cloroxs definition. Clorox uses a weighted average cost of capital (WACC) of 9% but doesnt reveal how that was determined. It is most likely they are using the Capital Asset Pricing Model (CAPM) to compute the equity cost of capital.
CT Capitals research has found that firms that focus on economic profits as well as ROIC, have a greater tendency to engage in value creating opportunities. The beneficial effect of higher free cash flows results in superior stock performance for their shareholders. The trend toward using other entitys capital is not confined to the manufacturing sector, as service entities also deploying labor outside of their cost structure.