18  Finance in a Nutshell
Then they could compare the ROIC with what they could earn if they invested 
their capital elsewhere—for example, in the stock market.
Lily and Nate had invested $10 million in their business, and in 2020 they 
earned about $1.8 million after taxes, with no debt. So they calculated their 
return on invested capital as 18 percent. They asked what a reasonable guess 
would be for the rate they could earn in the stock market, and we suggested 
they use 10 percent. They easily saw that their money was earning 8 percent 
more than what we were assuming they could earn by investing elsewhere, so 
they were pleased with their business’s performance.
We commented that growth is also important to consider in measuring 
financial performance. Lily told us that the business was growing at about 5 
percent per year. Nate added that they discovered growth can be expensive; to 
achieve that growth, they had to invest in new stores, fixtures, and inventory. 
To grow at 5 percent and earn 18 percent ROIC on their growth, they rein-
vested about 28 percent of their profits back into the business each year. The 
remaining 72 percent of profits was available to withdraw from the business. 
In 2020, then, they generated cash flow of about $1.30 million.
Lily and Nate were satisfied with 5 percent growth and 18 percent ROIC 
until Lily’s cousin Logan told them about his aggressive expansion plans for 
his own retail business, Logan’s Stores. Based on what Logan had said, Lily 
and Nate compared the expected faster growth in operating profit for Logan’s 
Stores with their own company’s 5 percent growth, as graphed in Exhibit 2.1. 
Lily and Nate were concerned that Logan’s faster-growing profits signaled a 
defect in their own vision or management.
“Wait a minute,” we said. “How is Logan getting all that growth? What 
about his ROIC?” Lily and Nate checked and returned with the data shown 
in Exhibit 2.2. As we had suspected, Logan was achieving his growth by 
EXHIBIT 2.1  Expected Profit Growth at Logan’s Stores Outpacing Lily’s Dresses
After-tax operating profit,
$ thousand
3,000
2,500
2,000
1,500
1,000
500
0
Lily’s Dresses
Logan’s Stores
2020
2025
22
21
23
24

A New Concept  19
EXHIBIT 2.2  Lily’s Dresses Outperforming in Return on Invested Capital (ROIC) and 
Cash Flow
ROIC,
%
20
10
0
5
15
22
2020
21
23
24
2025
Lily’s Dresses
Logan’s Stores
Cash flow,
$ thousand
22
23
2020
21
24
500
2025
0
1,000
1,500
2,000
Lily’s Dresses
Logan’s Stores
investing heavily. Despite all the growth in operating profit, his company’s 
ROIC was declining significantly, so cash flow was slipping downward.
We asked the two why they thought their stores earned higher returns on 
capital than Logan’s. Nate said one reason was that their products were unique 
and cutting-edge fashion, so their customers were willing to pay higher prices for 
their dresses than for the products at many other dress shops. Lily added that each 
of their stores attracted more customers, so their sales per square foot (a proxy for 
fixed costs) were greater than Logan’s. As they saw it, Logan’s products were not 
much different from those of his competitors, so he had to match his prices to 
theirs and had less customer traffic in his stores. This discussion helped Nate and 
Lily appreciate that it was beneficial to consider ROIC along with growth.
A New Concept
Several years later, Lily and Nate called us with a great idea. They wanted to 
develop a new concept, which they called Lily’s Emporium. Lily’s Emporium 
would operate larger stores carrying a wider assortment of clothes and acces-
sories that their talented designers were working on. But when they looked 
at the projected results (they now had a financial-analysis department), they 
found that all the new capital investment to convert their stores would reduce 
ROIC and cash flow for four years, even though revenue and profits would be 

20  Finance in a Nutshell
EXHIBIT 2.3  Expansion’s Impact on ROIC and Cash Flow
ROIC,
%
20
10
16
12
14
18
2020
21
22
24
23
2025
Base case: Lily’s Dresses
Expansion case: Lily’s Dresses and Emporium
Cash flow,
$ thousand
22
2020
21
23
24
2025
0
500
1,000
1,500
2,000
Base case: Lily’s Dresses
Expansion case: Lily’s Dresses and Emporium
growing faster, as shown in Exhibit 2.3. After four years, cash flow would be 
greater, but they didn’t know how to trade off the short-term decline in ROIC 
and cash flow against the long-term improvement.
We affirmed that these were the right questions and explained that 
­answering them would require more sophisticated financial tools. We advised 
them to use discounted cash flow (DCF), a measure that is also known as 
­present value. DCF is a way of collapsing the future performance of the com-
pany into a single number. Lily and Nate needed to forecast the future cash 
flow of the company and discount it back to the present at the same opportu-
nity cost of capital we had used for our earlier comparisons.
We helped Lily and Nate apply DCF to their new concept, discounting 
the projected cash flows at 10 percent. We showed them that the DCF value 
of their company would be $53 million if they did not adopt the new concept. 
With the new concept, the DCF value would be greater: $62 million. (Actually, 
on our spreadsheet, we rounded to the nearest thousand: $61,911,000.) These 
numbers gave them confidence in their idea for Lily’s Emporium.
Should Lily and Nate Try to Maximize ROIC?
As they saw how these financial measures could help them build a more valu-
able business, Lily and Nate began to formulate more questions about mea-
suring value. Lily asked if their strategy should be to maximize their return on