1. Chapter 3: Fundamental Principles of Value Creation
Steven Arias
Finance 622

2. Overview
The author provides a scenario that illustrates a company’s growth cycle:
From Inception → Expansion → Going Public (IPO)
→ Forming a Conglomerate
With growth the company must apply different financial methods to measure its valuation.
Financial Methods that are applied are: Return on Invested Capital (ROIC), Economic Profit, and Discounted Cash Flow (DCF).

3. Fred’s Hardware Story: The Beginning
Fred owns a small chain of hardware stores
To measure financial results, Fred uses a combination of ROIC and Economic Profit.

4. The Importance of ROIC in Business Valuation
ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital
ROIC is a “telling gauge for comparing the relative profitability levels of companies.”
ROIC is the benchmark for comparing company performance.
ROIC shows how much cash is going out of a business in relation to how much is coming in.
ROIC is expressed as percentage. If the ROIC is greater than the company’s WACC, then the company is creating value for its investors.
Investopedia.com, “Spot Quality With ROIC.”

5. Understanding Economic Profit
Economic Profit can be expressed as the spread between ROIC less the Cost of Capital (WACC), multiplied by the amount of invested capital.
If Fred closed down his low returning store, average ROIC would increase, but economic profit would decline.
The objective is to increase Economic Profit over the long-term, not ROIC.
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

6. Fred and Sally-Projected Operating Profit
A Faulty Method to assess financial performance is to compare only Net
Operating Profit among companies.

7. Fred and Sally-Projected Economic Profit
Using Net Operating Profit distorts true financial performance since it does not indicate how a company finances its growth.
Sally was achieving her growth by investing lots of capital; Sally’s company ROIC is declining significantly causing the Economic Profit to decrease despite the increase in operating profit.
As shown, the true financial results are measured from the ROIC and Economic Profit

8. Fred’s New Concept: Fred’s Superhardware
Initiating Fred’s new idea of a Superhardware store, Fred
observed the following:
Economic Profit would decline for the first several years,
because of the new capital requirement.
After year Four, Economic Profit would be greater.
How do you tradeoff the short-term decline in Economic
Profit against long-term improvement?

9. Discounted Cash Flows (DCF)
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
 The DCF value of Fred’s company without the new concept was lower than with the new concept; therefore, Fred should pursue the new concept.

10. Fred Goes Public
Fred decides to go public to raise capital for more stores and provide an opportunity for some employees to become owners. But there are additional considerations Fred must understand.
The Financial Market is different than the Real Market → Good performance in one market does not necessarily mean good performance in the other.
Why?
In Real Markets, the focus is maximizing the Present Value of Future Cash Flow or Future Economic Profit.
In the Financial Market, Real Market principles still apply, but the system becomes more complex because the company’s valuation (stock price) is contingent on what investors think those shares should be and trades based whether the current price is above or below the estimate of the intrinsic value.

11. Determining Value of the Company
The Intrinsic Value of the company’s stock is determined by the forecast of the company’s performance and discounted expected future cash flow.
Stock price is determined by how well the company meets expectations
The stock price increases with higher than expected economic profit.
The stock price declines with less than expected economic profit.
If you perform as expected, the return to shareholders should equal their opportunity cost.
As a publicly traded company, management must maximize the intrinsic value of the company and properly manage the expectations of the financial market.

12. Fred Expands Into Related Formats
Fred decides to form a conglomerate with new business units that consist of Fred’s Furniture and Fred’s Garden Supplies.
The Financial Market presents the demand for accurate expectations of economic profits. Therefore, management needs control and planning systems that look at past and future financial measures.

13. Summary
The accurate method of measuring financial results in the Real Market is a combination of using ROIC and Economic Profit.
Use DCF to collapse future performance into a single number; therefore, it allows management to determine whether a project should be undertaken.
In the financial market, management must maximize the intrinsic value of the company and properly manage the expectations of the financial market.