126  The Stock Market Is Smarter Than You Think beliefs espoused by managers and finance professionals are inconsistent with the fundamental principles of valuation and are erroneous. We also find that executives are often overly focused on earnings and earn- ings growth. Earnings don’t drive value in their own right; only cash flows do. Companies with attractive growth and returns on invested capital will also generate good earnings. The market sees through earnings that aren’t backed up by solid fundamentals, such as earnings increases from share repurchases or from mergers and acquisitions that don’t earn adequate returns on capital. Managers should also not be concerned about noneconomic events that re- duce earnings, such as asset write-downs or the effects of changes in account- ing rules. Nor should they be concerned about delivering smooth earnings or meeting short-term consensus earnings forecasts. Finally, myriad myths have grown up about how the market values companies based on measures unrelated to the companies’ economic per- formance. None stand up to scrutiny. There is no value premium from diver- sification, from cross-listing, or from size for size’s sake. Conversely, there is no conglomerate discount, only a performance discount for many diversified companies. Dividends and share repurchases don’t create value, but markets react positively when management signals it will be disciplined about future investments. 127 8 Return on Invested Capital As Chapter 3 explains, the higher a company can raise its return on invested capital (ROIC), and the longer it can earn a rate of return on that capital greater than its cost of capital, the more value it will create. So it is critical to every strategic and investment decision to be able to understand and predict what drives and sustains ROIC. Why do some companies develop and sustain much higher returns on cap- ital than others? Consider a classic example from the days of the tech boom at the turn of the millennium. Two newcomers at the height of the boom in 2000 were the companies eBay and Webvan. In November 1999, eBay’s market capitalization was $23 billion, while Webvan’s was $8 billion. Over the years that followed, eBay continued to prosper, reaching a market capitalization of more than $70 billion in 2015, when it spun off its subsidiary PayPal. By mid- 2018, the combined market capitalization of eBay and PayPal was more than $160 billion. Webvan, in contrast, disappeared into bankruptcy and liquida- tion after just a few years. To understand why, we can look at what these com- panies’ underlying strategies meant for their respective returns on invested capital. The core business of eBay is an online marketplace that collects a small amount of money for each transaction between a buyer and a seller. The busi- ness needs no inventories or accounts receivable, and it requires little invested capital. Once the service started and a growing number of buyers used eBay, more sellers were attracted to it, in turn drawing in still more buyers. More- over, the marginal cost of each additional buyer or seller is close to zero. Econ- omists say that a business in a situation like eBay’s exhibits increasing returns to scale. In such a business, the first competitor to grow big can generate a very high ROIC and will usually create the bulk of value in its market. If, as in eBay’s case, the business easily expands across borders, the potential for value creation becomes even greater.