1. Fundamental Principles of Value Creation
Fred’s Hardware Story
Small chain of hardware stores
Superhardware stores
Additional retail stores
Fred’s Furniture
Fred’s Garden Supplies

2. Fred’s Hardware-Low Return Store Analysis
Measure financial results by Return on Invested Capital
Measure financial results by Economic Profit
Invested
Economic
ROIC
WACC
Spread
capital
profit
(percent)
($thousands)
Entire Company 18 10 8
10,000
800
Without low return store 19 9
8,000
720

3. Fred and Sally-Projected Operating Profit
Fred’s sister Sally was achieving better operating profits.

4. Fred and Sally-Projected Economic Profit
Operating Profit is not the best way to measure financial results
As shown the true financial results are measured from the ROIC and Economic Profit

5. Fred’s New Concept of Fred’s Superhardware stores

6. Discounted Cash Flows
This is a way of collapsing the future performance of the company into a single number.
Forecast future cash flow of the company and discount it to the present at the same opportunity cost of capital.
Economic profit and discounted cash flow (DCF) are the same.
Discount economic profit to the amount of capital you have invested today and you get DCF

7. Fred goes Public
The financial market is different than the real market.
The financial market reacts to expectations
These expectations are what investors want to be steady
Investors depend on their money to grow
The financial market is like betting on football
Stock prices go up with the growth of a company
They exceed stock price with higher than expected economic profit.
The stock price declines with less than expected economic profit

8. Fred expands into related Formats
Fred’s Furniture and Fred’s Garden Supplies
The financial market presents the demand for accurate expectations of economic profits
Economic profits must be managed

9. Summary
The accurate method of measuring financial results in the real market is with Economic Profit
Use DCF to collapse future performance into a single number
This enables you to forecast the future cash flow of the company and discount it to the present at the same opportunity cot of capital
In the financial market a company must forecast future economic profits accurately to keep investors happy and to continue investing