The economic profit (EP) and risk-adjusted return (RAR) figures are part of the fundamental metrics needed for the proper development of the value-based management system implemented in BBVA. They also represent an essential variable in the determination of the incentive system in place for the management team.
The EP is defined as the portion of the economic profit in excess of the cost of capital employed; that is, it is the profit generated in excess of market expected returns on capital.
In calculating the EP, a set of adjustments are made to the net attributable profit to obtain the economic profit. These adjustments include: substituting generic provisions with an allocation based on expected losses; accounting for the changes in unrealized capital gains on the holding portfolios; applying the difference between all the accounting positions of Global Markets and their market value; and reflecting changes in the total net-asset value due to exchange-rate variations in Group companies’ holdings. In 2011, these adjustments basically corresponded to the change in the value of the portfolios of equity holdings, and subtracted €2,978m from the accounting result, making the economic profit €25m.
These calculations, whose evolution in the medium to long term is very useful for determining the intrinsic value of a business, may be temporarily distorted by market volatility. For that reason, it is important to have recurrent figures that are primarily the result of business with customers. This is, therefore, the part of these metrics that is truly manageable and, as a result, the one affecting the remuneration system for the Entity’s management team. The data are obtained by excluding those business units whose earnings are influenced by fluctuations in capital gains in their portfolios, and cycle-adjusted loss is included for the purposes of calculating expected loss. Thus the accumulated recurrent adjusted profit in 2011 was €4,691m, which was very similar to the figure in 2010 (€4,700m).
From the adjusted profit, we have to subtract the result of multiplying the average economic risk capital or ERC for the period (€27,716m as of December 31, 2011) by the percentage cost of capital. This cost is based on information drawn from analysts’ consensus. It is different for each area and business unit in the Group, and is equivalent to the rate of return demanded by the market, in return on equity terms.
This procedure gives the economic profit, which amounted to -€3,358m in the year. However, the recurrent economic profit stood at €1,976m, once more reflecting the degree to which BBVA generates profits in excess of the cost of capital employed, and thus economic value for its shareholders.
Finally, the RAROC measures the return earned by each business unit adjusted by the risk it bears. Comparing the adjusted profit against the average economic risk capital (ERC) for the period gives the BBVA Group a RAROC of 0.1%, while its recurrent RAROC was 20.1%.