Power of Economic Profits

Ever wondered that despite higher profits why a company trades at a lower valuation multiple and market cap than a company whose profits are less but is trading at a premium. Generally, whenever we analyze any business to measure profitability, we use the Profit & Loss statement. In this statement the profit which we see is the accounting profit. Accounting profit is widely used metric for financial analysis, as it is homogeneous irrespective of the geography.

Let's understand the working of accounting profit.

This is how a P&L statement looks like. It is pretty much straightforward to understand.

We start with revenues then subtract all the explicit costs such as employee, material, manufacturing then we add subtract other income, interest and depreciation, and after paying tax we get the final PAT or the accounting profit.

One main feature of accounting profit is it takes into account all the explicit costs which are affecting the good sold and to find profitability but doesn't take into the consideration the implicit cost affecting the business.

Implicit costs here can be said as Implicit cost of Invested Equity Capital (or Cost of Equity)

Cost of Equity in a company is used to evaluate potential investment opportunities. As a company, we need to invest in projects which can generate higher returns than the cost of equity.

Further, as financial analysts we use cost of equity, to determine the appropriate discount rate for future cash flows. It also means, how much returns the investors expect for holding the equity.

Let's take an example of Indian oil and Nestle India.

Here, we can see that despite higher profits generated by Indian Oil, the economic profit is negative due to higher cost of equity, and also return on equity is less for Indian Oil. As a result, the MCap of Indian Oil is less than Nestle India despite higher accounting profits.

Although there are a number of factors which decide the premium and MCap for a company, but with this concept we can partially understand how much premium a company can get based on the economic profits it is generating.