Going Public  21 EXHIBIT 2.4  Economic Profit Is Higher with Lower-Performing Stores in the Mix ROIC, % Cost of capital, % Spread, % Invested capital, $ thousand Economic profit, $ thousand Entire company 18 10 8 12,000 960 Without lower-performing stores 19 10 9 9,500 855 2 See Chapter 10 for a detailed discussion of these two valuation approaches. invested capital. She pointed to the fact that some stores outperformed others. For example, some were earning an ROIC of only 14 percent. If the business closed those lower-performing stores, they could increase their average return on invested capital. Our advice was to focus not on the ROIC itself, but on the combination of ROIC (versus cost of capital) and the amount of capital. A tool for doing that is called economic profit. We showed them how economic profit applies to their business, using the measures in Exhibit 2.4. We defined economic profit as the spread between ROIC and cost of capi- tal multiplied by the amount of invested capital. In Lily and Nate’s case, their economic profit forecast for 2024 would be the 8 percent spread by $12 million in invested capital, or $960,000. If they closed their low-returning stores, their average ROIC would increase to 19 percent, but their economic profit would decline to $855,000. This is because even though some stores earn a lower ROIC than others do, the lower-earning stores are still earning more than the cost of capital. Using this example, we made the case that Lily and Nate should seek to maximize economic profit, not ROIC, over the long term. For Nate, though, this analysis raised a practical concern. With different methods available, it wasn’t obvious which one to use. He asked, “When do we use economic profit, and when do we use DCF?” “Good question,” we said. “In fact, they’re the same.” We prepared Exhibit 2.5 to show Nate and Lily a comparison, using the DCF we had previ- ously estimated for their business: $61,911,000. To apply the economic-profit method, we discounted the future economic profit at the same cost of capital we had used with the DCF. Then we added the discounted economic profit to the amount of capital invested today. The results for the two approaches are the same—exactly, to the penny.2 Going Public Now Lily and Nate had a way to make important strategic decisions over multiple time periods. Lily’s Emporium was successful, and the next time they called us, they talked excitedly about new ambitions. “We need more 22  Finance in a Nutshell EXHIBIT 2.5  Identical Results from DCF and Economic-Profit Valuation Valuation, by method, $ thousand 61,911 DCF Value 22,220 61,911 39,691 Present value of economic profit Invested capital Total value Discounted cash flow (DCF) Economic profit capital to build more stores more quickly,” Nate said. “Besides, we want to provide an opportunity for some of our employees to become owners. So we’ve decided to go public.” They asked us to help them understand how going public would affect their financial decision making. “Well,” we said, “now’s the time to learn what the distinction is between financial markets and real markets and how they are related to each other. You’ll want to understand that good performance in one market does not nec- essarily mean good performance in another.” Up until now, we’d been talking with Lily and Nate about the real market. How much profit and cash flow were they earning relative to the investments they were making? Were they maximizing their economic profit and cash flow over time? In the real market, the decision rule is simple: choose strategies or make operational decisions that maximize the present value of future cash flow or future economic profit. When a company enters the capital market, the decision rules for the real market remain essentially unchanged. But life gets more complicated, because management must simultaneously deal with the financial market. When a company goes public and sells shares to a wide range of investors who can trade those shares in an organized market, the interaction (or trading activity) between investors and even market speculators sets a price for those shares. The price of the shares is based on what investors think those shares are worth. Each investor decides what he or she thinks the value of the shares should be and makes trades based on whether the current price is above or below that estimate of the intrinsic value.