Valuation Measuring and Managing the Value of Companies

1. 1Start from after-tax operating profit (NOPAT), not net income. The passages define the starting point as after-tax operating profit, and Lily's Dresses had no debt, so its $1.8 million after-tax profit is the operating figure.
2. 2Measure net investment as the cash put into working capital and fixed assets (property, plant, equipment) for the period. For Lily and Nate, that means new stores, fixtures and inventory. Growth is not free; it costs invested capital.
3. 3Compute FCF = NOPAT − net investment. Lily's Dresses earned about $1.8 million and generated cash flow of about $1.30 million, so the implied net investment is about $0.5 million.
4. 4Strip out anything noncash. The source states that noncash accounting charges and changes in accounting methods do not create value because they do not change cash flow. Do not let them move the number.
5. 5Forecast FCF by year, not just the current year. The Emporium conversion lowered ROIC and cash flow for four years before cash flow rose above the base case. A one-year view would have rejected it.
6. 6Discount the forecast at the opportunity cost of capital (10% in the example) and sum it. This DCF value is the single number the source calls a collapse of future performance.
7. 7Run the base case and the strategy case side by side and compare DCF values. Lily's base case was $53 million; the Emporium case was $61.911 million.
8. 8Cross-check with economic profit. Discounted economic profit plus capital invested today must equal the DCF value (here $61,911 thousand, exactly). A mismatch signals a modeling error.

Lily's Dresses invested $10 million, earned about $1.8 million after tax with no debt (18% ROIC), and grew about 5% a year. Because growth required new stores and fixtures, it generated cash flow of about $1.30 million, which implies roughly $0.5 million of net investment. Logan's Stores showed faster profit growth, but he bought it with heavy investment. His ROIC declined significantly and his cash flow slipped downward, while Lily's cash flow stayed higher. The Emporium conversion tested the same logic over time. Projected cash flow and ROIC fell for four years, then cash flow exceeded the base case. Discounting the forecast FCF at 10% gave $53 million without the concept and $61.911 million with it. The economic-profit method gave the identical figure: discounted economic profit plus invested capital summed to $61,911 thousand. The decision turned on the discounted FCF stream, not on the first four years.

• If profit is growing faster than a rival's but ROIC and cash flow are falling, treat the growth as bought with investment (Logan's pattern), not as superior performance.
• If a strategy lowers FCF for several years but the discounted FCF exceeds the base case at the same cost of capital, adopt it (Emporium: $62 million vs. $53 million).
• If an earnings improvement comes from a noncash charge or an accounting-method change, assign it zero value because FCF is unchanged.
• If a margin or EPS gain coincides with cuts to product development, maintenance or brand building, discount it. Those cuts inflate near-term cash flow at the expense of future cash flow.
• If the DCF value and the economic-profit value (PV of economic profit plus invested capital) differ, stop and fix the model before using either figure.

• Treating earnings as value. Many executives, boards and media treat accounting earnings and value as the same. The tell: targets and bonuses are set on EPS or profit growth while ROIC and cash flow are never reported.
• Chasing profit growth while ignoring net investment. The tell: operating profit rises on schedule while ROIC declines and cash flow slips (Logan's Stores).
• Judging a project on its early years. The tell: the Emporium plan is rejected because ROIC and cash flow fall for four years, without a discounted comparison to the base case.
• Inflating current FCF by underinvesting. The tell: a company posted 11–16% EPS growth for seven years while revenue growth declined, and it was later forced into a painful rebuild.
• Using a cost of capital that differs between scenarios, or treating it as a cash cost. The tell: base and expansion DCFs use different discount rates, or the cost of capital appears as a line item in cash flow, when it is an opportunity cost.

• ▸Year: list each forecast year in its own column.
• ▸NOPAT (after-tax operating profit): enter operating profit net of tax; exclude interest and any noncash accounting-method effects.
• ▸Net investment: enter the increase in working capital plus fixed assets (stores, fixtures, equipment) for the year.
• ▸FCF = NOPAT − net investment: calculate for each year.
• ▸Invested capital and ROIC: enter invested capital and NOPAT ÷ invested capital for each year to see whether growth is dragging returns down.
• ▸Cost of capital: enter the single opportunity-cost rate (10% in the example) and use the same rate in every scenario.
• ▸Base-case DCF: enter the sum of the discounted FCF without the new strategy.
• ▸Strategy-case DCF: enter the sum of the discounted FCF with the new strategy.
• ▸Reconciliation check: enter PV of economic profit plus invested capital today and confirm it equals the DCF value.

1. 1Define the object you are valuing: the whole operating enterprise, not the equity and not a quarter's earnings. Corporate value is the sum of the present values of all future expected free cash flows, discounted at the company's cost of capital. Anything that is not an operating cash flow stays out of this number and is handled later, when you move from enterprise value to value per share.
2. 2Reorganize the financial statements before you forecast anything. The book gives this its own chapter (Ch. 11) ahead of performance analysis and forecasting. The aim is to separate invested capital (working capital plus property, plant, and equipment) from the financing claims on it. That separation produces the after-tax operating profit and the capital base you need.
3. 3Measure historical ROIC as after-tax operating profit divided by capital invested in working capital and PP&E. Compare it with the opportunity cost of capital. The rule from the source: value is created when ROIC exceeds the cost of capital. At or below it, growth may not create value.
4. 4Forecast performance as a combination of growth and ROIC, not as a revenue line with a margin assumption. The goal is the combination of growth and ROIC that yields the highest discounted value of cash flows. Test each forecast year against two questions: what ROIC does it imply, and does growth at that ROIC add value?
5. 5Estimate continuing value for the period beyond the explicit forecast (Ch. 14). It carries a large share of enterprise value, so apply the same economic discipline to it: the competitive laws that erode extraordinary returns also bound your terminal assumptions.
6. 6Estimate the cost of capital (Ch. 15) and discount the free cash flows and continuing value to the present. Sum them to get enterprise value. Then move to value per share (Ch. 16).
7. 7Cross-check intrinsic value against the market price, and treat a gap as a question, not a verdict. Market performance can differ from intrinsic value creation, generally because investors' expectations change. The market may also be an unreliable indicator for some companies some of the time. Your DCF is the anchor that lets you tell the two cases apart.
8. 8Screen every strategic decision for value, not for short-term EPS. Ask whether the action raises the discounted cash flows of the collective of current and future shareholders. Reject actions that lift today's share price while damaging the company later, such as shortchanging product development, quality, or safety.

Take the book's Lily and Nate story. They run a small chain of midpriced clothing stores, Lily's Dresses, and ask how to know whether their results are attractive. The answer is to measure ROIC: after-tax operating profit divided by capital invested in working capital and PP&E. The test is then whether that ROIC exceeds their opportunity cost of capital. If it does, growth through new stores, then Lily's Emporium, and later furniture and garden supplies, adds to corporate value. If it does not, expansion may add revenue but not value. The passages give no numbers for this story, so treat it as the logic to apply to your own figures. A contrasting case comes from a large company whose new CFO set a standing rule that every business unit must increase profits faster than revenues, every year. That rule forces margin gains regardless of whether a unit's investments earn more than the cost of capital, so it can cut off long-term value-creating opportunities. The source also notes there is no empirical link between EPS accretion in acquisitions and value created: deals that raise EPS and deals that dilute it are equally likely to create or destroy value. A manager who anchors on discounted free cash flow and ROIC against cost of capital avoids both traps.

• If ROIC is above the cost of capital, then evaluate growth as value-adding and look for ways to fund more of it. If ROIC is at or below the cost of capital, then do not assume growth creates value; fix returns first.
• If a proposed action raises near-term EPS but hurts product development, quality, safety, or future regulatory and consumer exposure, then reject it. Corporate value is the long-term discounted cash flow, not today's share price.
• If an acquisition is judged mainly by EPS accretion or dilution, then discard that test and value the deal on discounted free cash flow, since EPS effects do not predict value creation.
• If the stock price and your intrinsic value diverge, then first check whether investor expectations changed, and keep your DCF as the guide. Do not adjust the DCF toward the price without a cash-flow reason.
• If a forecast implies extraordinary returns persisting indefinitely, then treat it as suspect. The laws of competition erode extraordinary profits, as the Internet bubble and pre-2007 financial-sector profits showed.

• Valuing earnings instead of cash flows: the model is anchored on EPS or net income growth. The tell is that no capital base, ROIC, or free cash flow line appears in the forecast.
• Assuming growth is always good: revenue growth is forecast with no check on ROIC versus cost of capital. The tell is rising value with ROIC at or below the cost of capital.
• Letting the market price set the answer: the DCF is tuned until it matches the current share price. The tell is assumptions that were changed only to close the gap, with no operating rationale.
• Short-termism built into the targets: rules such as profit must grow faster than revenue every year in every unit. The tell is units skipping investments that earn above the cost of capital to hit the ratio.
• Extrapolating extraordinary profits into continuing value: terminal assumptions ignore competition. The tell is that continuing value dominates enterprise value and implies returns far above the cost of capital forever.

• ▸Reorganized invested capital: list working capital and PP&E, separate from financing claims.
• ▸After-tax operating profit (latest year): enter the operating figure, excluding financing items.
• ▸ROIC: after-tax operating profit divided by invested capital.
• ▸Cost of capital: enter your estimate and its source.
• ▸ROIC minus cost of capital: positive means growth can create value; at or below zero means do not assume it does.
• ▸Forecast growth and ROIC by year: note the implied ROIC each year and whether it is defensible against competition.
• ▸Continuing value share: record continuing value as a share of enterprise value and the return assumption behind it.
• ▸Enterprise value (sum of discounted free cash flows): then note the steps to value per share.
• ▸Market value gap and explanation: record the gap to the market price and the expectation change that explains it, if any.

1. 1Start with the real-market decision rule. For every strategic or operational choice, pick the option that maximizes the present value of future cash flow or economic profit. Write that rule at the top of the strategy document before listing any options.
2. 2Estimate the value of each alternative business strategy separately, using DCF. Do not rank strategies by revenue growth or by expected share-price reaction.
3. 3Decompose each option into return on invested capital (ROIC) and growth. Value comes from investing capital at returns above the cost of capital, so state for each option whether it raises ROIC, raises growth, or both.
4. 4Apply the conservation of value test to every proposed move (M&A, restructuring, financing change, accounting change). If the move does not increase cash flow and does not reduce risk, it does not create value. Reject it or reclassify it as cosmetic.
5. 5Build the corporate portfolio view by business unit. For each unit, ask whether your corporation is the best-positioned owner or whether the unit would perform better under someone else's ownership. Put units in the keep, fix, or divest group on that basis.
6. 6Separate operational improvement from portfolio pruning when you explain a ROIC gain. Rockwell's ROIC rose from about 12 percent to about 35 percent. Divesting lower-margin ancillary businesses contributed part of that, but most came from operational improvement in industrial automation.
7. 7Allocate resources to units and initiatives whose valuation shows ROIC above the cost of capital. Align strategic planning and performance management with those priorities so the organization executes them.
8. 8Check the financial market separately from the real market. Strong performance in one does not guarantee strong performance in the other. Investors pay for expected future performance, not past results or asset cost. Keep decisions anchored on intrinsic value, and do not chase the current share price.

Rockwell Automation (the passage's real example) shows the sequence. Between 1995 and 2018, revenues shrank from $13 billion to $7 billion because the company divested its aviation and power systems divisions. It spun off aviation (now Rockwell Collins) in 2001 and focused on core industrial automation. Total shareholder returns were 19 percent per year over 1995–2018, in the top quartile of industrial companies. A growth-first reading would call the shrinking revenue a failure. The value-first reading is that ROIC rose from about 12 percent in the mid-1990s to about 35 percent in 2018 (including goodwill). Part of the gain came from divesting lower-margin ancillary businesses, but the majority came from operational improvement in industrial automation. Management repeatedly stated its focus on cost and capital productivity. The lesson: portfolio decisions and operating decisions both created value through ROIC, and revenue was not the measure of success.

• If a strategic option raises revenue but does not raise cash flow or lower risk, then treat it as value-neutral at best and do not fund it.
• If a business unit would perform better under another owner, then divest it, even if doing so shrinks revenue.
• If ROIC is below the cost of capital and operational fixes are feasible, then fix the operations first. Rockwell's largest ROIC gains came from operations, not from divestitures alone.
• If the share price and your DCF value disagree, then trust the intrinsic-value analysis for the decision. The market can be an unreliable signal for some companies some of the time.
• If a choice among strategies is close, then choose the one with the higher present value of future cash flow, over the one with the better near-term share-price effect.

• Equating growth with value. The tell: plans cite revenue targets with no ROIC or cost-of-capital comparison.
• Managing for the short-term share price. The tell: decisions justified by an expected 'pop' rather than by the value to current and future shareholders.
• Holding units out of habit. The tell: no one can say why your corporation is the best owner of a unit, and the unit's performance lags peers.
• Crediting a ROIC gain to the wrong cause. The tell: improvement is attributed wholly to portfolio pruning or wholly to operations, without separating the two as in the Rockwell case.
• Confusing financial-market and real-market performance. The tell: a strong share price is taken as proof that the strategy is working, or the valuation is anchored on asset cost or past results.

• ▸Option / market / move: name the strategic choice (market entry, M&A, R&D, pricing, divestiture).
• ▸Business unit affected: identify the unit and whether your corporation is the best owner (yes/no, why).
• ▸Current ROIC vs. cost of capital: state both figures for the unit.
• ▸ROIC effect of the option: increase, decrease, or neutral, and the mechanism.
• ▸Growth effect of the option: expected change and the capital required to achieve it.
• ▸Cash flow impact: present value of future cash flow with and without the option.
• ▸Conservation of value test: does the option raise cash flow or reduce risk? If neither, flag as non-value-creating.
• ▸Operational vs. portfolio source of improvement: split the expected ROIC gain between the two.
• ▸Decision and resource allocation: fund, fix, or divest, with the owner and review date.

1. 1Start from the economic test, not the story. Write down the unit's return on invested capital (ROIC) and its cost of capital. In this framework, value is created only by investing capital at returns above the cost of capital. Without a visible ROIC spread, you have a claim of advantage, not an advantage.
2. 2Name the source in one of two categories. Either it commands a price premium (brand, innovation, prestige) or it achieves cost and capital efficiency (scale, unique resources). Write the source as a specific mechanism, such as 'customers pay more because X', never as a label like 'strong brand'.
3. 3Run the growth-capital test. Ask what happens to the capital you must deploy when customers double. If you must add drivers, trucks, warehouses and inventory in proportion, there are no increasing returns. Growth then earns only the ROIC the unit already earns, and 'winner take all' logic does not apply.
4. 4Check that the advantage is unassailable enough to earn even modest ROIC once the growth is paid for. State what stops a competitor from copying the source. If the answer is only 'we got big first', treat the advantage as unproven.
5. 5Assume erosion. Competition tends to erode advantages and the returns that come with them. Write the date or condition by which you expect the current source to weaken, and name the next source you are building or hunting for to replace it.
6. 6Stress-test premium pricing against the long term. Weigh the value of a lower price to buyers against the value of a higher price to shareholders and other stakeholders. A premium that signals prestige in a luxury good can add long-term value. A premium taken only because you hold a position (Turing's 5,000-percent increase) invites outrage and government investigation.
7. 7Value the advantage in scenarios, not a single point. Build a base case where the advantage holds and a downside where it erodes. Assign probabilities and compute the expected value, as in the book's two-scenario method. Then look for staged investments you can scale up on success and scale down on failure.
8. 8Screen out illusory value. Reject any step that does not raise ROIC, or growth at an attractive ROIC. That includes changes in who owns the claims to cash flows and accounting techniques that shift the timing of profit without changing cash flow. Meeting the next quarter's consensus forecast is not evidence of advantage.

The passages' clearest test case is the Internet-era 'winner take all' belief. Executives and investors held that getting big fast mattered most and that a business model could wait. The logic of increasing returns was applied to online pet supplies and grocery delivery. Run the growth-capital test on those firms. As the customer base grew, they had to invest, eventually unsustainably, in more drivers, trucks, warehouses and inventory. Capital scaled with revenue, so size alone did not raise returns. Step four then exposes the gap. In the book's words, many of these businesses lacked the 'unassailable competitive advantages required to earn even modest returns on invested capital.' When the laws of economics prevailed, ROIC was the ratio that had been forgotten. The Turing Pharmaceuticals case covers the premium-price side. After acquiring rights to a medication used for AIDS-related illnesses in 2015, the company raised the price per pill by more than 5,000 percent. The result was outrage, a wave of government investigations, and a CEO derided as 'the most hated man in America.' The passage calls this 'not looking far enough ahead.' A luxury good's premium that signals prestige can build long-term value, but a premium taken from a position of leverage over buyers cannot be defended the same way.

• If you cannot state ROIC against the cost of capital for the unit, then do not claim a competitive advantage. Calculate it first.
• If serving more customers requires proportionally more drivers, trucks, warehouses or inventory, then treat growth as earning only the existing ROIC. Do not underwrite 'increasing returns'.
• If the advantage rests on a price premium, then check whether it signals durable value to the buyer (prestige, a premium for innovation) or merely exploits a position. Only the first holds up over the long term.
• If a proposed action does not raise ROIC, or growth at an attractive ROIC, then classify it as not creating value, even if it lifts near-term earnings or reassigns claims on cash flow.
• If the current source of advantage is the only one you can name, then start a search for the next one now. Competition erodes advantages, so renewal is part of the strategy.

• Mistaking size for advantage. The tell: the plan says 'get big fast' and defers the business model, while capital needs rise one-for-one with customers.
• Forgetting ROIC. The tell: the case rests on revenue, users or growth rates, and no one in the room can say the return on invested capital or how it compares with the cost of capital.
• Treating extraordinary profits as permanent. The tell: results far above peers are explained by a 'new economy' or a special year, with no account of why competition will not erase them. The book cites the financial sector's profits before 2007–2009, which subsequent losses showed to be overstated.
• Extracting the premium without looking ahead. The tell: a price move justified only by the fact that buyers have no alternative, with no weighing of buyer value against shareholder and stakeholder value, as in the Turing case.
• Managing to the quarter. The tell: decisions are framed around meeting analysts' consensus earnings forecasts, or they push costs such as environmental cleanup or plant retrofits for future pollution rules into the future.

• ▸Unit and period: name the firm or business unit and the years analysed.
• ▸ROIC vs. cost of capital: enter both figures and the spread. If the spread is zero or negative, stop and record 'no demonstrated advantage'.
• ▸Source category and mechanism: choose price premium or cost/capital efficiency, then write one sentence on how it works (e.g., 'customers pay more because...').
• ▸Capital needed per unit of growth: list what you must add (vehicles, warehouses, inventory, plants) when customers double, and say whether it scales proportionally.
• ▸Barrier to imitation: state what prevents a competitor from copying the source. Write 'none identified' if that is the case.
• ▸Premium-price check: if you charge a premium, list buyer value vs. shareholder/stakeholder value and say whether it holds over the long term.
• ▸Erosion trigger and date: describe the condition or timeframe by which competition is expected to weaken this advantage.
• ▸Successor source: name the next source of advantage and the first step toward building it.
• ▸Scenarios: record base case (advantage holds) and downside case (advantage erodes), each with value and probability, and compute the expected value.

1. 1Split reported revenue growth into its three sources: portfolio momentum (market expansion), market share gains, and mergers and acquisitions. Put each source on its own line for every business unit, so you can see which part is organic and which was bought.
2. 2Rank organic growth first. The source research finds long-term revenue growth, particularly organic, is the most important driver of shareholder returns for companies with high returns on capital. Treat acquired growth as a separate line with its own return test.
3. 3Check the return on capital before you set a growth target. The organic-growth relationship holds for high-ROIC companies, and the same relationship was not found for low-ROIC companies. For a high-ROIC unit, growth is the priority. For a low-ROIC unit, fix returns before you chase growth.
4. 4Run an earnings-versus-revenue divergence test. Put EPS growth and revenue growth side by side over several years. If EPS keeps rising while revenue growth falls, assume the margin gains are being borrowed from the future until you can show a real efficiency source.
5. 5Audit the growth-feeding spend: marketing, R&D, product development, brand building, maintenance. R&D correlates strongly with long-term TSR. If these lines are cut to hit an earnings target, record the cut as a revenue-growth risk, not as a saving.
6. 6Screen for pulled-forward revenue. Look for discounts that move purchases from next quarter into this one to hit a quarterly EPS target. In the CFO survey, 39 percent said they would do this. Strip those sales out of the underlying growth rate.
7. 7For any acquisition that adds revenue, do not stop at the question of whether it dilutes EPS over the first year or two. That is the most common question managers ask. Ask instead whether the purchased revenue earns returns above the cost of capital.
8. 8Judge growth over a long horizon. The research finding is that companies with a long strategic horizon create more value. Review each unit's growth against a multi-year view, and do not reset the target to the next annual report.

A global consumer products company grew EPS 11 to 16 percent a year for seven years. Managers credited improved efficiency, and investors pushed the share price above its peers'. The company was cutting investment in product development and brand building to inflate short-term profits, and its revenue growth was declining. That divergence between rising EPS and falling revenue growth is the signal the step-four test is built to catch. Managers eventually had to admit what they had done. The company then went through a painful rebuilding period, and its stock price took years to recover. A second case shows the same logic in a policy rule. A new CFO of a very large company required every business unit to grow profits faster than revenues, every year. Some units already had profit margins above 30 percent and returns on capital of 50 percent or more. To meet the rule, they were forgoing growth opportunities with 25 percent profit margins in the years ahead. The rule improves the next annual report and shrinks the revenue base that long-term value depends on.

• If EPS growth is steady but revenue growth is falling, then treat the earnings as suspect and examine cuts to R&D, marketing and brand spending before you credit efficiency.
• If a unit earns a high return on capital, then pursue organic revenue growth even at a lower margin. A 25 percent margin opportunity on a high-ROIC base is still worth taking.
• If a unit's return on capital is low, then do not assume faster revenue growth will lift shareholder returns. Fix returns first.
• If a target requires profits to outgrow revenues every year, then reject it as a blanket rule, because it forces units to forgo growth opportunities.
• If an acquisition is justified mainly by its first-year or second-year EPS effect, then re-test it on returns above the cost of capital before counting its revenue as value-creating growth.

• Counting bought revenue as growth. The tell is that total growth looks healthy but organic growth is flat or falling, and the deal case rests on EPS accretion.
• Trusting margin-led earnings growth. The tell is EPS rising while revenue growth declines, with no concrete explanation of the efficiency gain.
• Cutting discretionary spend to hit a quarterly target. The tell is marketing and R&D lines falling in the quarter the target is at risk. The source survey found 80 percent of CFOs would do this.
• Pulling sales forward with discounts. The tell is a strong quarter followed by a weak one, and discounting that clusters near the quarter-end target.
• Chasing size for its own sake. The tell is a 'get big fast' rationale with no stated return on invested capital. The source cites the Internet bubble as the result when return on capital is forgotten.

• ▸Business unit and period: name the unit and the multi-year window you are reviewing.
• ▸Revenue growth by source: record the percentage from market expansion, share gains, and acquisitions.
• ▸Organic share of growth: state organic growth as a share of total growth.
• ▸Return on capital vs. cost of capital: record whether the unit is high-ROIC or low-ROIC, since this decides how much growth matters.
• ▸EPS growth vs. revenue growth gap: enter both rates and the multi-year trend in the gap.
• ▸Growth-feeding spend trend: record R&D, marketing, product development and brand spending against prior years.
• ▸Pull-forward check: list discounts or timing moves made to hit a quarterly EPS target.
• ▸Acquired revenue test: for each deal, state expected return versus cost of capital, not only EPS dilution.
• ▸Verdict and action: mark as sustainable, borrowed from the future, or needs a returns fix, and name the next step.

1. 1Fix the formula before you measure: ROIC = NOPAT ÷ book Invested Capital, where Invested Capital is operating assets minus operating liabilities. Anything that is not an operating asset or liability stays out of both numerator and denominator.
2. 2Reorganize the financial statements first (the source's Chapter 11). Split operating items from nonoperating items, provisions and reserves (Chapter 21). Treat leases (Chapter 22) and retirement obligations (Chapter 23) consistently, because they move the denominator and the numerator.
3. 3Build NOPAT from operating profit after taxes only. Strip out changes in accounting timing, ownership of claims to cash flows, and other items that alter reported profit without altering cash flow. The source says these do not create value.
4. 4Build Invested Capital from the same operating perimeter: operating assets less operating liabilities, at book value. Check that every item in NOPAT has its matching asset or liability in Invested Capital, and that none is left out.
5. 5Divide, then compare ROIC with the cost of capital (Chapter 4 and Chapter 15). The source's test is whether capital is invested at rates of return that exceed the cost of capital. The absolute ROIC figure alone does not answer that.
6. 6Read ROIC together with growth. Value comes from ROIC and growth together, measured relative to the cost of capital. Growth at an attractive ROIC creates value, and anything that does not raise ROIC or grow at an attractive ROIC does not.
7. 7Tie the number to competitive advantage. Ask what sustains the return: only a well-defined advantage supports high ROIC and strong growth, and competition erodes advantages and returns over time. Name the advantage and the evidence that it will last.
8. 8Use ROIC to judge decisions, not only to report history. Test each proposed investment, target or rule by whether it creates cash flow at returns above the cost of capital. Do not judge it by its effect on EPS or on the ROIC of a single unit.
9. 9For capital-light models or unusual structures, check Chapters 24 and 25. They cover measuring performance in capital-light businesses and alternative ways to measure return on capital.

The source offers two cases. First, the Internet bubble: managers and investors lost sight of what drives ROIC, and many forgot the ratio entirely. They believed 'winner take all' meant getting big fast mattered more than building an effective business model. Online pet supplies and grocery delivery were assumed to enjoy ever-increasing returns. Yet each new batch of customers required more drivers, trucks, warehouses and inventory. That growth adds to Invested Capital, so the denominator rises with revenue, and without an unassailable competitive advantage NOPAT does not rise enough to earn even a modest ROIC. When the laws of economics prevailed, many of these businesses could not earn even a modest return on invested capital. Second, the short-term CFO rule: a relatively new CFO at a very large company requires every business unit to grow profits faster than revenues, every year. Some units already have margins above 30 percent and returns on capital of 50 percent or more. Meeting the rule means passing up long-term value-creating opportunities, because new investment at attractive returns would pull a 50 percent ROIC down. The source says such opportunities are skipped in favor of short-term earnings measures. The lesson from both: judge capital deployment by return versus cost of capital and by growth, and do not judge it by size or by this year's profit trajectory.

• If ROIC is above the cost of capital and a project can grow at that return, then fund the growth. Value rises with growth only when the return on the new capital is attractive.
• If a proposal raises revenue, size or EPS but does not raise ROIC or grow at an attractive ROIC, then treat it as value-neutral at best. Accounting timing and changes in ownership of claims do not create value.
• If a business earns well above its cost of capital, then do not hold it to a rule that profits must outgrow revenues every year. That rule blocks reinvestment that would still earn above the cost of capital.
• If a high ROIC has no named, defensible competitive advantage, then assume competition will erode it. Plan on lower returns and look for new sources of advantage.
• If extraordinary profits appear in a sector, then ask whether they are real and sustainable. Pre-2007 financial-sector profits were overstated, and the laws of competition should have flagged that they could not last.

• Mixing operating and nonoperating items, so NOPAT and Invested Capital cover different things. The tell: ROIC moves when a nonoperating asset, reserve or lease treatment changes, but the business has not changed.
• Treating growth as value in itself, as in the Internet bubble. The tell: capital (trucks, warehouses, inventory) rises in step with customers while the business has no clear advantage and earns less than the cost of capital.
• Managing to EPS or to a rule like 'profits must grow faster than revenue.' The tell: high-return units decline attractive investments because they would dilute the unit's own margin or ROIC.
• Quoting ROIC without the cost of capital. The tell: a return is called good or bad with no comparison to what the capital costs.
• Assuming today's ROIC lasts. The tell: the forecast holds a high return flat with no explanation of why competition will not erode the advantage.

• ▸Business / period: name the unit or company and the fiscal year or years analyzed.
• ▸Operating perimeter: list what you classify as operating versus nonoperating, including leases, retirement obligations, provisions and reserves.
• ▸NOPAT: operating profit after taxes, excluding nonoperating items and accounting-timing effects.
• ▸Operating assets (book value): total operating assets at the measurement date.
• ▸Operating liabilities (book value): total operating liabilities at the measurement date.
• ▸Invested Capital: operating assets minus operating liabilities.
• ▸ROIC: NOPAT ÷ Invested Capital.
• ▸Cost of capital and spread: your estimated cost of capital, and ROIC minus that cost.
• ▸Growth and capital need: planned revenue growth, plus the extra capital (assets such as trucks, warehouses, inventory) that growth requires, and the expected return on that new capital.
• ▸Competitive advantage and durability: name the advantage that sustains ROIC, how competition could erode it, and what would replace it.

1. 1Define the rate as an opportunity cost, not an accounting number. WACC is the return all capital providers (debt and equity) could earn elsewhere for bearing this business's risk. It is a required return for the risk, so never set it from the company's budget, target margin, or last year's reported interest expense.
2. 2Build it as a weighted average of the cost of debt and the cost of equity, weighted by each source's share of the company's capital. The source places the full build in Chapter 15 (Estimating the Cost of Capital). Chapter 4 covers risk, Appendix B derives WACC, Appendix C covers levering and unlevering the cost of equity, and Appendix F covers the market risk premium. Work from those, and do not improvise the inputs.
3. 3Match the rate to the cash flows. WACC serves investors in both debt and equity, so it discounts free cash flow, the cash flow available to all capital providers. Do not apply it to a cash flow that belongs only to shareholders.
4. 4Use one rate across every method in the same valuation. In the Lily's Emporium case, discounting future economic profit at the same cost of capital as the DCF gives identical results 'to the penny'. If the two methods disagree, the rates or the capital base differ, which means an error.
5. 5Set the rate against ROIC to read value creation. Value is created when ROIC exceeds the cost of capital. If ROIC is at or below it, growth may not create value. Calculate the spread (ROIC minus WACC) before judging any growth plan.
6. 6Back-test the rate as an expected return. If the company performs exactly as expected, shareholders earn exactly the discount rate, no more and no less. Check that the price today, the expected price in N years, and any dividends compound at your WACC.
7. 7Keep the rate separate from performance expectations. A better-than-expected outcome earns investors more than the cost of capital, and a worse one earns them less. Do not raise or lower WACC to reflect optimism or disappointment about results. Put those changes in the cash-flow forecast.
8. 8Review the rate when the risk of the business changes. The source's one exception to the principle that value comes only from cash flow is that an action that reduces risk can create value. Risk reduction therefore belongs in the cost of capital and must be reasoned explicitly.

Lily and Nate's company, Lily's Emporium, is valued at a 10 percent discount rate. Under the DCF method the value is $61,911 thousand. Under the economic-profit method, invested capital of $22,220 thousand plus the present value of future economic profit of $39,691 thousand also gives $61,911 thousand, because both use the same cost of capital. When the company goes public, the advisors apply the same rate to the share price. The shares sell at $20 today. If the company performs exactly as expected and expectations beyond five years do not change, the value in five years is $32 per share. With no dividends paid, an investor who buys at $20 and sells at $32 earns about 10 percent annualized, which equals the discount rate, so shareholders earn just their opportunity cost. A company that beats expectations lets shareholders earn more than 10 percent, and one that falls short leaves them with less. Lily's conclusion is that investor returns depend on performance relative to expectations, not on performance alone.

• If ROIC is above WACC, then growth adds value, so fund it. If ROIC is at or below WACC, then growth may not create value, so fix returns before expanding.
• If a DCF on free cash flow and an economic-profit valuation give different totals, then the discount rates or the invested-capital base are inconsistent. Reconcile them until both match exactly.
• If the cash flows discounted are free cash flows to all capital providers, then discount at WACC. Never mix this rate with equity-only cash flows.
• If a proposed action does not raise cash flow, then it creates value only if it reduces risk, and you must show the risk reduction in the discount rate rather than assume it.
• If the expected return implied by your price path (today's price versus the expected future price plus dividends) does not equal the discount rate, then the valuation is internally inconsistent. Re-examine either the rate or the forecast.

• Treating WACC as a hurdle chosen for convenience or target-setting. The tell is a rate unconnected to the business's risk and unchanged across very different businesses or projects.
• Using different rates for DCF and economic profit. The tell is the two valuations failing to match to the penny.
• Confusing performance with expectations: assuming a high return on shares means the company beat its cost of capital. The tell is judging value creation from share-price movement alone, when returns reflect changes in expectations.
• Raising growth targets while ROIC sits at or below the cost of capital. The tell is revenue-growth plans with no ROIC-versus-WACC comparison attached.
• Estimating the cost of capital from a quick formula without working through the build in Chapter 15, including leverage adjustments (Appendix C) and the market risk premium (Appendix F). The tell is inputs with no stated source or reasoning.

• ▸Business and cash-flow basis: state what is being valued and confirm the cash flows are free cash flow to all capital providers.
• ▸Cost of equity: enter the required return for equity investors and note the method and inputs used (see Chapter 15 and Appendices C and F).
• ▸Cost of debt (after tax): enter the debt cost and the tax treatment used.
• ▸Capital weights: enter debt and equity shares of total capital and their basis.
• ▸Computed WACC: weighted average of the two costs.
• ▸Forecast ROIC: enter the expected return on invested capital for the business or plan.
• ▸ROIC minus WACC spread: positive means growth creates value; zero or negative means it may not.
• ▸Rate used in DCF versus economic-profit valuation: record both and confirm they are identical.
• ▸Implied expected-return test: enter today's price, expected price in N years, dividends, and the annualized return, then compare to WACC.