Economic Income

Why would an analyst calculate “Economic Income” ? What is he trying to measure?

I can read the formula, but I need a logical way to understand and remember it. Anyone?

What you mean with economic income? Do you mean economic profit? Economic profit = NOPAT - $WACC.

Economic income is also a concept linked to the opportunity cost of capital.

Let us know.

Beats me. Ay quien sabe. When I was in graduate school in the late 1990’s Economic Value Added (EVA) was very populsr. I see that it is part of the CFA cirriculum. Basically, a consulting firm (Stern Stewart) developed a measure of profit that they claimed was better than accounting profit (Net Income). And for big fees, they would tell companies all about it and help them implement it.

Their primary argument was that Net Income didn’t have an explicit charge for the cost equity. Then there were like 100+ potential adjiustments to net income,but only a handful were key. The advocates think that making these adjsutments gives you a better view of company/management performance than accounting profit. There may be some value in it. I don’t really have a strong opinion one way or the other. But I am generally pretty skeptical of non-GAAP measurments.

What you mean with “non-GAAP measurements”? Accounting measures of profits come from a total different world than valuation models like EVA. Despite EVA starts from accounting measures, its intention is to calculate other type of return, the important one in my opinion. Economic profits shape markets, move capitals accross countries and create volatilities; change the world every day. Non-GAAP measurements are awesome.

I meant why would a company calculate its Economic Income? Why are we using the After-tax operating cashflow in the formula and not NI for example. Any idea?

Freejack, CFO is derived by making adjustments to Net Income. When using the indirect method, these adjustments are explicit and listed in the Cash Flow Statement. So you can use either CFO or Net Income as your starting point.

Harro, Net Income, or better yer EPS, is the distillation of millions of transactions into a single number. That is asking a lot of a single number! Maybe an analogy would be GDP. GDP is a single number distilling down billions of transactions. Neither can be the end of the story. In both cases there is necessarily much more to the story than a single number can measure.

Let me clarify my statement on being suspicious of non-GAAP measurements. I was thinking of companies providing alternative non-GAAP metrics in their financial statements. In my opinion, the default assumption here should be that these guys are trying to distort, obfuscate, or otherwise obscure results. In a less imperfect world, analysts are always onto the game. It does bring an interest dynamic. Financial statement preparers tend to think that they can fool the “market” with optics. Efficient markets suggest you cannot.

Economic Income is of the same vein as Economic Profit and Market Value Added, but different. It starts off with Accounting Income (i.e., Net Income, EPS, “the bottom line,” etc.) but adds back the change in the market values that occurred to tangible assets, generally including, (but possibly differing from) accounting (GAAP) depreciation; it can also consider changes of intangibles/goodwill.

Economic Income shows more of a realistic profile of a firm’s profits compared with GAAP accounting, which is really just residual revenue after revenue has been matched against all accrual-style expenses due in the period.

Actually, as I remember economic income starts from NOPAT (view company as a whole including creditor and stock holder), add back accounting depreciation and less economic depreciation. (NOPAT+ difference between accounting depreciation and economic depreciation). The process adjust the accounting cash flow to “economic cash flow” which I am not quite sure.

Apart from the difference between accounting & economic depreciations, the economic profit is a result of NOPAT-$WACC. This considers the opportunity cost of the capital invested.