Finally...What is "Making Money"?
Using return on invested capital, WACC, and economic profit to understand what qualifies as "making money". Plus economic profit vs. net profit.
We've already covered how to calculate the return on invested capital, what economic profit is, and how to calculate WACC, a common measure of the cost of invested capital.
Let's recall this company below.
After deducting the cost of invested capital, we found that this company has only generated returns in the first year, reflected by the positive economic profit for the first year and negative economic profit for the other two years. However, this company did have positive net profits in each of the three years from 2008 to 2010.
Here we have an interesting problem at hand. If a company has positive net profit but negative economic profit, would you say it is making money?
When we are calculating the net profit, we have deducted the cost of capital of creditors from the company's top-line; creditors' cost of capital is the financial expense of the company. On the other hand, the cost of capital of shareholders is not deducted from the companys top-line.
Why is that the case?
Cost of capital of shareholders can be described as the opportunity cost for shareholders to invest in a certain company. A commonly used figure for such cost of capital is the average profitability level in the industry. However, we don’t actually need to pay shareholders such an expense. According to the principle of historical cost, we know money not paid shouldn’t be recorded on the statement.
Now we are positive that when calculating the net profit, we only deducted one type of cost, which is the cost of capital of creditors. When calculating economic profit, we deducted the cost of invested capital from the return on the invested capital. Since the cost of invested capital has included both cost of capital of creditors and that of shareholders, we have deducted two types of costs before getting to economic profit.
Why does a company have positive net profit but negative economic profit?
When a company has positive net profit but negative economic profit, it means that the company has made profits but it hasn't made money for shareholders after taking into consideration of their cost of capital. The money that shareholders earn from this company is less than what it could be if they invest in other companies. Among the companies in this industry, this company is lagging behind in profitability.
Let’s think about another question. If the economic profit of one company is positive, what is the excess part?
Knowing our answer to the previous question, this is not difficult to answer. We just see that economic profit is the residue return minus the cost of capital of shareholders and creditors. This refers to the extra money the company earns after deducting the average profitability level in the industry and bank interests. The extra money, or economic profit, is what shareholders could get on top of the average profitability level if they invest in this particular company rather than any other company in the industry.
Another follow-up question is that if the economic profit is the real money that the company earns for shareholders, what’s the result when I add all the economic profits of the company every year throughout the company's lifecycle? It is called the value created by the company for shareholders.
We have mentioned that a good company should at least make money. Through several episodes of discussions, we have gone on great lengths to figure out what actually qualifies as "making money"; it doesn’t mean making sales, profit, growth rate, or even profitability rate. Making money, in the short-term, means having positive economic profit, and in the long-term, means creating value for shareholders. Any good company should meet this basic requirement, i.e. making positive economic profit and creating value for shareholders. Once this bar is met, we can then aim for higher goals and move from good to great.
