Valuation, 7th Edition

2Finance in a Nutshell

Companies create value when they earn a return on invested capital (ROIC) greater than their opportunity cost of capital.¹ If the ROIC is at or below the cost of capital, growth may not create value. Companies should aim to find the combination of growth and ROIC that drives the highest discounted value of their cash flows. In so doing, they should consider that performance in the stock market may differ from intrinsic value creation, generally as a result of changes in investors’ expectations.

To illustrate how value creation works, this chapter uses a simple story. Our heroes are Lily and Nate, who start out as the owners of a small chain of trendy clothing stores. Success follows. Over time, their business goes through a remarkable transformation. They develop the idea of Lily’s Emporium and convert their stores to the new concept. To expand, they take their company public to raise additional capital. Encouraged by the resulting gains, they develop more retail concepts, including Lily’s Furniture and Lily’s Garden Supplies. In the end, Lily and Nate are faced with the complexity of managing a multibusiness retail enterprise.

The Early Years

When we first met Lily and Nate, their business had grown from a tiny boutique into a small chain of trendy, midpriced clothing stores called Lily’s Dresses. They met with us to find out how they could know if they were achieving attractive financial results. We told them they should measure their business’s return ...