42  Fundamental Principles of Value Creation
higher returns on capital). Its economic profit would be $250. Clearly, creating 
$250 of economic profit is preferable to creating $50.
Finally, measuring performance in terms of economic profit encourages a 
company to undertake investments that earn more than their cost of capital, 
even if their return is lower than the current average return. Suppose Value 
Inc. had the opportunity to invest an extra $200 at a 15 percent return. Its av-
erage ROIC would decline from 20 percent to 18.6 percent, but its economic 
profit would increase from $50 to $60.
Conservation of Value
A corollary of the principle that discounted cash flow (DCF) drives value is 
the conservation of value: anything that doesn’t increase cash flows doesn’t 
create value. That means value is conserved, or unchanged, when a company 
changes the ownership of claims to its cash flows but doesn’t change the total 
available cash flows—for example, when it substitutes debt for equity or is-
sues debt to repurchase shares. Similarly, changing the appearance of the cash 
flows without actually changing the cash flows—say, by changing accounting 
techniques—doesn’t change the value of a company.10 While the validity of 
this principle is obvious, it is worth emphasizing because executives, inves-
tors, and pundits so often forget it, as when they hope that one accounting 
treatment will lead to a higher value than another or that some fancy financial 
structure will turn a mediocre deal into a winner.
The battle over how companies should account for executive stock options 
illustrates the extent to which executives continue to believe (erroneously) 
that the stock market is unaware of the conservation of value. Even though 
there is no cash effect when executive stock options are issued, they reduce 
the cash flow available to existing shareholders by diluting their ownership 
when the options are exercised. Under accounting rules dating back to the 
1970s, companies could exclude the implicit cost of executive stock options 
from their income statements. In the early 1990s, as options became more ma-
terial, the Financial Accounting Standards Board (FASB) proposed a change to 
the accounting rules, requiring companies to record an expense for the value 
of options when they are issued. A large group of executives and venture 
capitalists thought investors would be spooked if options were brought onto 
the income statement. Some claimed that the entire venture capital industry 
would be decimated because young start-up companies that provide much 
of their compensation through options would show low or negative profits.
The FASB issued its new rules in 2004,11 more than a decade after taking 
up the issue and only after the bursting of the dot-com bubble. Despite dire 
10 In some cases, a company can increase its value by reducing its cost of capital by using more debt 
in its capital structure. However, even in this case, the underlying change is to reduce taxes, but the 
overall pretax cost of capital doesn’t change. See Chapter 33 for further discussion.
11 Financial Accounting Standard 123R, released in December 2004, effective for periods beginning after 
June 15, 2005.