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A managing-value focus does not create value through financial manipulations. Rather, it creates value through developing sound strategic and operating plans for a company's businesses. The link between sound strategy and value creation is a tight one. As many CEOs have learned, financial manipulation on its own seldom works.
Many companies are not in as desperate a condition as we outlined for EG. Most companies, however, would benefit from a thorough review of restructuring opportunities. Perhaps it is because many companies that have gone through massive restructuring believe that it will only happen once. As we discussed in Chapter 1, we believe that restructuring and an active market for corporate control are now facts of corporate life. Consequently, managers need to ensure that they identify and act on value-creation opportunities regularly— not just once when they are a takeover target. This is best done through fundamental changes in the way their businesses are structured and operated. By acting now, value managers can avoid the need to react under duress.
Fundamental Principles of Value Creation
To effectively measure and manage the value of a company, you need to understand the fundamental principles of value creation. Before immersing you in the details in Chapter 4, we want to make sure that these fundamentals are clear. This chapter illustrates the basics of value creation with the story of Fred's Hardware.
Fred's business goes through a remarkable transformation. Fred starts out as the owner of a small chain of hardware stores. Then he develops the idea of Fred's Superhardware and converts his stores to the new concept. To expand, Fred goes public to raise additional capital. His success leads Fred to develop additional retail concepts, such as Fred's Furniture and Fred's Garden Supplies. In the end, Fred is faced with the complexity of managing a retail conglomerate.
The Early Years
In the early years, Fred owned a small chain of hardware stores. Not being a finance person, he asked us how he would know if he was achieving attractive financial results. To keep things simple, we told Fred that he should measure the return on invested capital (after-tax operating profits divided by the capital invested in working capital and property, plant, and equipment) and compare it with what he could earn if he invested his capital elsewhere (say the stock market).
Fred calculated his return on invested capital as 18 percent. We suggested that he could earn 10 percent by investing his capital in the stock market, so Fred was pretty satisfied, since his investment was earning more than he could earn elsewhere.
Exhibit 3.1 Fred's Hardware—Low Return Store Analysis
ROIC WACC Spread capital profit
(percent) (percent) (percent) (S thousand) ($ thousand)
intire company 18 10 8 10.000 800
Without low return store 19 10 9 8,000 720
Fred then asked if he should try to maximize return on invested capital. One of his stores was earning only a 14 percent return on invested capital and if he closed it, he could increase average return on invested capital. We told him that what he should care about is not the ROIC itself, but the combination of ROIC (versus cost of capital) and the amount of capital, expressed as economic profit. We showed him a simple example (Exhibit 3.1).
Economic profit can be expressed as the spread between ROIC less the cost of capital, multiplied by the amount of invested capital. In Fred's case, economic profit was $800,000. If he closed down his low returning store, average ROIC would increase, but economic profit would decline. Even though the store earns a lower ROIC than the other stores, it still earns more than its cost of capital. The objective is to maximize economic profit over the long-term, not ROIC. Fred was convinced. He set out to maximize economic profit.
Almost immediately, Fred came back very unhappy. His sister Sally, who owned Sally's Stores, had just told him about her aggressive expansion plans. Exhibit 3.2 shows the projected growth of Sally's Stores' operating profit next to Fred's. As you can see, Sally's operating profit was projected to grow much faster. Fred didn't like the idea of his sister bettering him.
Exhibit 3.2 Fred and Sally—Projected Operating Profit
Exhibit 3.3 Fred and Sally—Projected Economic Profit
Wait a minute, we said. How is Sally getting all that growth? What about her economic profit? Fred went back to check and came back with Exhibit 3.3. Yes, indeed, the way Sally was achieving her growth was by investing lots of capital. Her company's ROIC was declining significantly, leading to a decrease in economic profit despite the growth in operating profit. Fred was relieved and went off to explain it all to Sally.
Fred's New Concept
Fred was happy with the economic profit framework for a number of years. Then he came back to us. He wanted to develop a new concept called Fred's Superhardware. But when he looked at the projected results (he now had a financial analysis department), he found that economic profit would decline in the next few years if he converted his stores to the new format because of the new capital investment required (Exhibit 3.4). After four years, economic profit would be greater, but he didn't know how to trade off the short-term decline in economic profit against the long-term improvement.