In 2013, Microsoft reported $21.9 billion in net income. By any accounting measure, it was one of the most profitable companies on earth. Yet its share price had been flat for a decade, and activist investors were circling. The market saw something the income statement hid: Microsoft was earning enormous profits on an enormous capital base, and much of that capital—the Nokia handset disaster, the Surface RT writedown, cash hoarded at low yields—was earning returns barely above, or below, what it cost to hold.
This is the central deception of accounting profit. It stops counting after subtracting the cost of debt (interest) but never charges the business for the cost of equity. A company can grow reported earnings for years while quietly destroying value, because equity capital *feels* free. It is not. It is usually the most expensive money on the balance sheet.
Economic profit corrects this. And once you decompose it into a driver tree, you stop managing a P&L and start managing the machinery of value creation itself.
The formula is deceptively simple:
Economic Profit = Invested Capital × (ROIC − WACC)
Or equivalently: EP = NOPAT − (Invested Capital × WACC)
You already know the components—NOPAT, invested capital, WACC. What matters at this level is what the equation *reveals* about behavior.
The spread (ROIC − WACC) is the engine. Invested capital is the amplifier. A business earning a 4-point spread on $500 million of capital generates $20 million of economic profit. Double the capital at the same spread and you double the value creation. But—and this is where most operators stumble—*growth only creates value when the spread is positive.* Growing a business that earns below its cost of capital destroys value faster the faster it grows. This is why "grow revenue" is not a strategy; it's a bet whose sign depends entirely on the spread.
Consider the practical implication for how you evaluate a division. A business unit posting a 22% ROIC on $200M of capital, growing at 3%, is worth more than a unit posting 11% ROIC on $600M growing at 12%—if your WACC is 10%. The first earns a 12-point spread; the second earns one point. Revenue growth is seducing the board while the second unit is barely clearing its hurdle. The economic-profit lens exposes this instantly.
The most powerful thing about EP is not its use in valuation—it's its use as a management system. When you charge every business unit for the capital it consumes, three behaviors change overnight:
The lesson for the CFO: economic profit is not a reporting exercise. It is a behavioral instrument. Where you place the capital charge—and at what rate—determines what your organization optimizes.
An economic-profit number tells you *whether* value was created. A driver tree tells you *why*, and *which lever to pull*. This is the analytical heart of the module.
Start by decomposing ROIC, because the spread is where value lives. The classic decomposition:
ROIC = NOPAT margin × Capital turnover
Where:
This is the DuPont logic, but applied to *operating returns on total capital* rather than return on equity, which is what makes it CFO-grade rather than analyst-grade. It strips out the distortions of leverage and financing that ROE smuggles in.
Now push each branch down another level:
The margin branch decomposes into gross margingross marginGross margin is the share of revenue left after subtracting the direct cost of producing goods or services, expressed as a percentage of revenue.View full definition →, SG&A as a percentage of sales, and R&D intensity—each a leadership lever owned by a specific executive. Pricing power lives here. So does operating leverage.
The turnover branch decomposes into fixed-capital turns (revenue ÷ PP&E) and working-capital turns (revenue ÷ net working capitalnet working capitalWorking capital is the difference between a company's current assets and current liabilities, measuring short-term liquidity and the funds available to run daily operations.View full definition →). This is where days-sales-outstanding, days-inventory, and days-payable live. It is almost always the branch operators ignore and where CFOs find the fastest value.
Finally, the tree has a second trunk: growth. Value = f(spread, growth, duration). You model growth as the reinvestment rate multiplied by ROIC on incremental capital. The critical distinction—and the one that separates sophisticated value modeling from spreadsheet theater—is between *return on existing capital* and *return on new capital*. A company can have a glorious legacy ROIC and be pouring new investment into projects earning below WACC. The blended number looks healthy while the marginal decision destroys value.
Here is the Monday-morning application. Take your economic profit and build the tree three layers deep, then quantify the *sensitivity* of enterprise value to each leaf. Ask: if we improve this leaf by one unit, how much EP—and how much enterprise value—do we create?
This produces a ranked list of value levers specific to your business. For a distribution business, the answer is almost always working-capital turns and payment terms. For a software business, it's gross margingross marginGross margin is the share of revenue left after subtracting the direct cost of producing goods or services, expressed as a percentage of revenue.View full definition → and the ROIC on new-customer-acquisition spending. For a capital-intensive manufacturer, it's asset utilization and the incremental return on the next plant.
The discipline is to convert the tree into owned targets. Every leaf gets an executive and a number. The VPVPA clear statement of the benefits your product delivers, the problems it solves and why customers should choose you over alternatives.View full definition → of Operations owns inventory turns. The CROCROConversion Rate Optimization (CRO) is the systematic practice of increasing the percentage of users who complete a desired action, using data, testing, and user research.View full definition → owns the NOPAT margin on new revenue. The head of the business unit owns the spread. When compensation ties to the leaf a manager controls—rather than to a corporate-level EP number they cannot move—the tree becomes an incentive system, not a diagnostic slide.
A warning on precision. The tree is powerful precisely because it is disaggregated, but disaggregation invites false accuracy. Invested capital definitions vary; goodwill from acquisitions inflates the capital base and can crush a divisional ROIC unfairly. Decide deliberately whether to include or exclude goodwill—include it to judge acquisition discipline, exclude it to judge operating performance—and hold the definition constant. Inconsistent capital definitions across units will produce a tree that lies with confidence.
Knowledge check
1. Why can a company report record accounting profits while simultaneously destroying shareholder value?
2. In the economic profit framework, what does the phrase 'the spread is the engine, invested capital is the amplifier' most accurately convey?
3. A division head proposes aggressively growing revenue in a business unit whose ROIC is below its WACC. From an economic profit standpoint, what is the correct assessment?
4. Select ALL correct answers about how economic profit differs from accounting profit.
Select all the correct answers.
5. Select ALL correct answers about the equation EP = Invested Capital × (ROIC − WACC).
Select all the correct answers.
The driver tree's greatest strategic use is arbitrating the perennial tension between margin, turns, and growth—three levers that trade against each other and rarely improve simultaneously.
Consider the archetypal choice. A retailer can raise margins by cutting promotional spend, but this slows turns as inventory sits and revenue softens. Or it can chase turns through aggressive discounting, sacrificing margin. Amazon made this choice explicit and famous: it deliberately suppressed margin to maximize turnover and growth, betting that a low-margin, high-velocity, capital-efficient model would generate more economic profit over a longer duration than a fat-margin competitor. The value driver tree is the only framework that lets you evaluate that trade quantitatively, because it holds ROIC constant as the unit of measurement while margin and turns move in opposite directions.
The CFO's judgment call is which lever your business model is structurally built to win on. You cannot excel at all three. Costco optimizes turns and suppresses margin. A luxury house optimizes margin and accepts slow turns. The strategic error is fighting your own model—demanding luxury margins from a volume business or volume turns from a premium one.
First, re-underwrite your capital allocation using incremental spreads. Pull every material investment of the last three years and compute the ROIC on the incremental capital deployed, not the blended corporate number. You will almost certainly find that a meaningful share of new capital is earning below WACC while being masked by legacy assets. That analysis alone justifies the exercise.
Second, attack the turnover branch before the margin branch. Margin improvement requires pricing power or cost restructuring—slow, politically expensive, often out of finance's direct control. Working-capital release is faster, sits squarely in the CFO's domain, and improves both ROIC (through lower capital) and free cash flowfree cash flowFree Cash Flow is the cash a company generates from operations after funding the capital expenditures needed to maintain and grow its asset base.View full definition → simultaneously. A twenty-percent reduction in inventory days can move divisional economic profit more than a full point of gross margingross marginGross margin is the share of revenue left after subtracting the direct cost of producing goods or services, expressed as a percentage of revenue.View full definition →, and you can execute it in two quarters.
Third, reset hurdle rates by unit, not by corporation. A single corporate WACC applied across a diversified enterprise systematically overinvests in high-risk units (whose hurdle should be higher) and underinvests in stable ones (whose hurdle should be lower). The driver tree, built with unit-specific capital charges, corrects this cross-subsidy. This is where the cost-of-capital work from earlier in the track meets the value-driver work here—the WACC is not a single number stapled to the enterprise; it is a set of hurdle rates matched to the risk of each spread.
The deepest insight of the economic-profit lens is that it dissolves the artificial wall between finance and operations. Every operating decision—a payment-terms negotiation, a pricing move, a factory investment—resolves into a change in one leaf of the tree, and every leaf resolves into a change in the spread or the capital base. The CFO who has internalized this stops asking "what did we earn?" and starts asking "what did we earn *above the cost of the capital we consumed to earn it*, and which lever moves that number most?"
1. Charge for equity, or you will reward value destruction. Accounting profit ignores the cost of equity; economic profit does not. Growing a below-WACC business destroys value faster the faster it grows—so treat the sign of the spread, not the direction of revenue, as the first question.
2. Decompose ROIC into margin × turns, then push each branch three layers deep. Assign every leaf to a named executive with a specific target. The tree only creates value when it becomes an ownership mapmapUsing software to automate repetitive marketing tasks and campaigns, enabling personalisation at scale across channels like email, web, and social.View full definition →, not a diagnostic slide.
3. **Measure returns on *incremental* capital, not blended capital.** Legacy ROIC masks value-destroying new investment. Re-underwrite the last three years of capital deployment on a marginal basis—it is the single most revealing analysis you can run this quarter.
4. Attack working-capital turns first. It improves ROIC and free cash flowfree cash flowFree Cash Flow is the cash a company generates from operations after funding the capital expenditures needed to maintain and grow its asset base.View full definition → simultaneously, sits in your direct control, and executes faster than any margin initiative.
5. Match hurdle rates to unit risk. A single corporate WACC cross-subsidizes risky units and starves stable ones. Unit-specific capital charges make the driver tree tell the truth.