How Useful Is the Economic Profit in Measuring Value Creation?

Abstract

It has been considered that firms' major objective is value creation and management's major role is managing activities to create value. Performance measures relevant for value creation are indispensable because management can use them to set measurable goals of value creation, to monitor the value creating activities and to evaluate the performance in terms of the value creation. Much attention has been paid to an economic profit as a performance measure relevant for value creation. Usefulness of the economic profit has been often explained in terms of the consistency with theoretical model of the firms' value, which is the sum of discounted future free cash flow. It is still unclear, however, what the economic profit itself measures, what kind of information the economic profit generates. The purpose of this paper is to clarify the role of economic profit in the context of management for value creation by providing clear understanding of what is measured by the economic profit.