Economic value added

The DCF tells you what a business is worth, but it's silent about when the value is earned. Economic profit re-slices the same value so that each year confesses whether it created or destroyed:

Economic profit (EP) = NOPAT − WACC × Invested Capital
                     = (ROIC − WACC) × Invested Capital

Read the second form aloud: the spread, times the money at work. Say a company has ₹8,000 crore invested at 14% against a 9% cost of capital. It earned NOPAT of ₹1,120 crore. But ₹720 crore of that was merely rent owed to capital, so only the remaining ₹400 crore = (14% − 9%) × 8,000 is profit in the economist's sense. Accounting profit asks "did we earn more than zero?" Economic profit asks the only question owners should care about: "did we earn more than the capital could have earned elsewhere?" A firm can report record PAT every year of its life and never once earn a positive EP. Phase 2 taught you to distrust earnings quality. This is a deeper distrust, of earnings sufficiency.

EVA (Economic Value Added) is Stern Stewart's trademarked version of the same idea. It's EP computed on a NOPAT and capital base scrubbed with their adjustments: capitalise R&D and treat it as an asset, add back non-cash reserve movements, and so on. You already make the substantive adjustments from first principles in your clean builds of returns on capital (leases on, R&D capitalised where material, goodwill both ways). So treat "EVA" and "economic profit" as one concept. EP is the generic name and EVA is the branded one. Get consistency right. The NOPAT in the numerator must belong to the capital in the denominator.

Does economic profit give the same value as a DCF?

The equivalence theorem says DCF and EP always agree. This is the second big proof here, and it's worth working through with numbers until you believe it. The claim:

Value = Invested Capital₀ + PV of all future economic profits

Take a firm with IC₀ = ₹2,000 crore, earning ROIC 18% on all capital, reinvesting to grow at g = 6% forever, WACC 12%.

Route 1: DCF via the value-driver formula. NOPAT₁ = 18% × 2,000 = 360. RR = 6/18 = 1/3. FCF₁ = 240. V = 240/(0.12 − 0.06) = ₹4,000 crore.

Route 2: invested capital plus PV of EP. EP₁ = (18% − 12%) × 2,000 = 120. Invested capital grows at 6%, because that's what reinvestment does, so EP grows at 6% too. Check year 2: IC₁ = 2,120, NOPAT₂ = 381.6, capital charge = 254.4, EP₂ = 127.2 = 120 × 1.06 ✓. PV of the growing EP stream = 120/(0.12 − 0.06) = 2,000. Value = 2,000 + 2,000 = ₹4,000 crore ✓.

Identical, always, and it's no coincidence. The algebra telescopes: FCF_t = NOPAT_t − ΔIC_t, and the ΔIC terms net against the capital charges when you discount. Worked example 1 grinds out a year-by-year tie-out so you can watch it happen.

Look at what the decomposition gives you. Of this firm's ₹4,000 crore value, ₹2,000 crore is just the capital handed back at cost, and ₹2,000 crore is the moat, the PV of the spread. A zero-spread firm is worth what was put in and no more. The market-facing twin is MVA (market value added) = market value − invested capital = the market's estimate of PV(future EP). Meet a company trading at 4× book invested capital and the EP lens translates instantly. The price asserts that three-quarters of the value is future spread. Should you believe it? That's Phase 4's question, now stated in crores.

Why use economic profit when you already have a DCF?

So why keep EP on the dashboard if it "adds nothing" to the DCF? Practitioners have good reasons:

1. It localises the verdict in time. A DCF is one number about eternity. An EP series shows this year's creation or destruction, so you can watch a moat erode, with EP shrinking on a growing capital base, years before the DCF headline moves.
2. It prices the treadmill. Managements grow NOPAT by piling up capital, and EP charges them for it. EP gives the cleanest single-number answer to "did the Corus acquisition / the new mega-plant / the diversification actually pay for itself?"
3. It's the right compensation metric. Pay a CEO on EPS and you finance EPS games, as the incentives section shows. Pay on EP, or on ROIC with a growth gate, and the capital charge follows every rupee they deploy. When you find EP or ROIC inside a comp plan, your prior on how well they'll allocate goes up. That's incentive arithmetic, and sentiment has nothing to do with it.
4. Its failure modes are instructive. EP on one noisy year misleads as badly as one year of ROIIC. Book invested capital understates for asset-light intangible compounders, so their EP looks absurdly high, the same caveat that applies to ROIC. Cyclical EP has to be read mid-cycle. Use 5 to 10 year EP trends against the capital base.

What is residual earnings?

Residual earnings is the equity-side twin. Economic profit charges the whole capital base for the whole cost of capital, which makes it an entity measure, in the same world as NOPAT, invested capital and WACC. Run the same idea one layer down, on the shareholders' own money, and you get residual earnings, sometimes called residual income:

Residual earnings (RE) = Net income − r × Book equity
                       = (ROE − r) × Book equity          r = cost of EQUITY

It's the same sentence at a different claim level: the spread, times the shareholders' money at work. And the same theorem follows, in the residual income form you'll build for banks and then generalise to any company:

Equity value = Book equity₀ + PV of all future residual earnings, discounted at r

Reconciling this with the entity model takes one line. Run it once by hand, because it's the cleanest proof that these are one model in two outfits. Take the firm above: IC₀ = ₹2,000 crore, ROIC 18%, g 6%, WACC 12%, so the entity route gives an enterprise value of ₹4,000 crore. Now give it ₹600 crore of net debt at 8% pre-tax and 25% tax, which leaves book equity of ₹1,400 crore. By the entity route the equity is worth 4,000 − 600 = ₹3,400 crore.

Then take the equity route. With a debt weight of 15%, the cost of equity implied by a 12% WACC is 13.0588%. Net income is 360 − 600 × 0.08 × 0.75 = ₹324 crore, an ROE of 23.14%. Residual earnings are 324 − 0.130588 × 1,400 = ₹141.18 crore. Book equity compounds at the same 6%, so the perpetuity gives 1,400 + 141.18/(0.130588 − 0.06) = **₹3,400 crore**. Both routes agree to the rupee, as they must whenever the leverage assumptions are consistent and the accounting obeys clean surplus.

Economic profit or residual earnings: which should you use?

Which one should you reach for? It depends on where the information is. Use economic profit when the operating story is the story, because it's immune to how the balance sheet is financed. Use residual earnings when the equity claim is the thing you can observe reliably. Banks and insurers fit that description, because an entity cash flow doesn't exist for them. So does any company whose value is mostly book plus a spread, instead of a long cash-flow forecast. You'll get the fuller treatment when you value banks later in this phase: the multistage version, the persistence factor, and the accounting adjustments that decide whether the book value you started from means anything.