40  Fundamental Principles of Value Creation
had low growth but increased their ROICs outperformed the faster-growing 
companies that did not improve their ROICs.
One final factor for management to consider is the method by which it 
chooses to improve ROIC. A company can increase ROIC by either improv-
ing profit margins or improving capital productivity. With respect to future 
growth, it doesn’t matter which of these paths a company emphasizes. But 
for current operations, at moderate ROIC levels, a one-percentage-point in-
crease in ROIC through margin improvement will have a moderately higher 
impact on value relative to improving capital productivity. At high levels of 
ROIC, though, improving ROIC by increasing margins will create much more 
value than an equivalent ROIC increase by improving capital productivity. 
Exhibit 3.10 shows how this works for a company that has a 9 percent cost 
of capital.
The reason for this relationship is best explained by an example. Con-
sider a company with zero growth, $1,000 of revenues, $100 of profits, and 
$500 of invested capital (translating to a 10 percent margin, a 50 percent 
ratio of invested capital to revenues, and ROIC of 20 percent). One way to 
increase ROIC by one percentage point is to increase the profit margin to 
10.5 percent, increasing profits by $5. Since the company is not growing, 
the $5 of extra profits translates to $5 of cash flow each year going forward. 
Discounting at a 10 percent cost of capital, this represents a $50 increase in 
value. The company could also increase ROIC by reducing working capital. 
If it reduced working capital by $24, ROIC would increase to 21 percent 
($100 divided by $476). The company’s value would increase only by the 
$24 one-time cash inflow from reducing working capital. Future cash flows 
would not be affected.
Economic Profit Combines ROIC and Size
You can also measure a company’s value creation using economic profit, a 
measure that combines ROIC and size into a currency metric (here we use the 
EXHIBIT 3.10  Impact on Value of Improving Margin vs. Capital Productivity
Increase in value from improving ROIC by 1 percentage point1 
% change
ROIC, %
Through margin 
improvement
Through capital 
productivity
Ratio of margin impact to 
capital productivity impact
10
20.0
13.5
1.2x
20
6.7
2.9
2.3x
30
4.0
1.2
3.4x
40
2.9
0.6
4.6x
1 For a company with a 9% cost of capital.

Economic Profit Combines ROIC and Size  41
U.S. dollar). Economic profit measures the value created by a company in a 
single period and is defined as follows:
Economic Profit
Invested Capital
ROIC
Cost of Capital
=
×
−
(
)
In other words, economic profit is the spread between the return on invested 
capital and the cost of capital times the amount of invested capital. Value Inc.’s 
economic profit for year 1 is $50 (Value Inc. must have $500 of starting capital 
if it earns $100 at a 20 percent return in year 1):
Economic Profit =
×
−
=
×
=
$
(
%
%)
$
%
$
500
20
10
500
10
50
Volume Inc.’s economic profit in year 1 is zero (Volume Inc. must have $1,000 
of starting capital if it earns $100 at a 10 percent return in year 1):
Economic Profit =
×
−
=
×
=
$ ,
(
%
%)
$ ,
%
$
1 000
10
10
1 000
0
0
You can also value a company by discounting its projected economic profit at 
the cost of capital and adding the starting invested capital. Value Inc. starts 
with $500 of invested capital. Its economic profit in year 1 is $50, which grows 
at 5 percent. Discounting the growing economic profit at a 10 percent discount 
rate gives a present value of economic profit of $1,000.9 Use these amounts to 
solve for value:
Value
Starting Invested Capital
PV Projected Economic Profit
=
+
=
(
)
$
$ ,
$ ,
500
1 000
1 500
+
=
The value of Value Inc. using the economic-profit approach is $1,500, exactly 
the same as with the discounted-cash-flow (DCF) approach.
Economic profit is also useful for comparing the value creation of differ-
ent companies or business units. Consider Value Inc.’s economic profit of $50. 
Suppose Big Inc. had $5,000 in invested capital but earned only a 15 percent 
return on capital (and assume it doesn’t have investment opportunities with 
9 The present value of economic profit for a growing perpetuity is economic profit in year 1 divided by 
the cost of capital minus the growth rate. For Value Inc., the present value of economic profit is there-
fore $50/(10% – 5%).