This Book  15
This Book
This book is a guide to how to measure and manage the value of a company. 
The faster companies can increase their revenues and deploy more capital 
at attractive rates of return, the more value they create. The combination of 
growth and return on invested capital (ROIC), relative to its cost, is what 
drives cash flow and value. Anything that doesn’t increase ROIC or growth at 
an attractive ROIC doesn’t create value. This category can include steps that 
change the ownership of claims to cash flows, and accounting techniques that 
may change the timing of profits without actually changing cash flows.
This guiding principle of value creation links directly to competitive ad-
vantage, the core concept of business strategy. Only if companies have a well-
defined competitive advantage can they sustain strong growth and high returns 
on invested capital. To the core principles, we add the empirical observation 
that creating sustainable value is a long-term endeavor, one that needs to take 
into account wider social, environmental, technological, and regulatory trends.
Competition tends to erode competitive advantages and, with them, re-
turns on invested capital. Therefore, companies must continually seek and 
exploit new sources of competitive advantage if they are to create long-term 
value. To that end, managers must resist short-term pressure to take actions 
that create illusory value quickly at the expense of the real thing in the long 
term. Creating value is not the same as, for example, meeting the analysts’ 
consensus earnings forecast for the next quarter. Nor is it ignoring the effects 
of decisions made today that may create greater costs down the road, from en-
vironmental cleanup to retrofitting plants to meet future pollution regulations. 
It means balancing near-term financial performance against what it takes to 
develop a healthy company that can create value for decades ahead—a de-
manding challenge.
This book explains both the economics of value creation (for instance, how 
competitive advantage enables some companies to earn higher returns on in-
vested capital than others) and the process of measuring value (for example, 
how to calculate return on invested capital from a company’s accounting 
statements). With this knowledge, companies can make wiser strategic and 
operating decisions, such as what businesses to own and how to make trade-
offs between growth and return on invested capital. Equally, this knowledge 
will enable investors to calculate the risks and returns of their investments 
with greater confidence.
Applying the principles of value creation sometimes means going against 
the crowd. It means accepting that there are no free lunches. It means relying 
on data, thoughtful analysis, a deep understanding of the competitive dynam-
ics of your industry, and a broad, well-informed perspective on how society 
continually affects and is affected by your business. We hope this book provides 
readers with the knowledge to help them throughout their careers to make and 
defend decisions that will create value for investors and for society at large.

17
2
Finance 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 bou-
tique 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 on invested capital: after-tax operating profits divided by 
the capital invested in working capital and property, plant, and equipment. 
1 A simple definition of return on invested capital is after-tax operating profit divided by invested 
capital (working capital plus fixed assets). ROIC’s calculation from a company’s financial statements is 
explained in detail in Chapters 10 and 11.