68 FUNDAMENTAL PRINCIPLES OF VALUE CREATION

SUMMARY

This chapter showed that value is driven by expected cash flows. Cash flow, in turn, is driven by expected returns on capital and growth. These are the principal lessons of valuation and corporate finance. The remainder of this book discusses how to apply these concepts, both in more technical terms (Part Two) and as a manager (Part Three). Before we move on to the details, however, we first present empirical evidence that long-term ROIC, growth, and cash flow do indeed drive value.

REVIEW QUESTIONS

1. Why should Fred be more interested in economic profit than returns? How does economic profit relate to growth planning?
2. What prompts the need to move from period-to-period metrics, such as ROIC or economic profit, to discounted cash flow?
3. Compare and contrast the economic profit to discounted cash flow approaches. Identify a key advantage of the economic profit model over the discounted cash flow model.
4. Identify the two key drivers to cash flow. How do these drivers impact corporate value?
5. Identify the five key lessons of value creation.
6. The returns that investors earn are driven not by company performance, but by “performance relative to expectations.” Discuss.
7. What advantage might exist using a multiples approach to corporate valuation versus either the discounted cash flow model or the economic profit model?
8. Firms A and B are constant growth firms, identical in every aspect except that the ROIC for A is 15 percent and B is 5 percent. Assume that management is in the process of establishing an investment rate of either 40 percent or 60 percent for each firm. Compute the estimated value for each investment rate for each firm given the following information: