Transcript Fundamental Principles of Value Creation

Fundamental Principles of Value Creation
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Fred’s Hardware Story
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Small chain of hardware stores
Superhardware stores
Additional retail stores
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Fred’s Furniture
Fred’s Garden Supplies
Fred’s Hardware-Low Return Store
Analysis
• Measure financial results by Return on Invested Capital
• Measure financial results by Economic Profit
Invested
Economic
ROIC
WACC
Spread
capital
profit
(percent)
(percent)
(percent)
($thousands)
($thousands)
Entire Company
18
10
8
10,000
800
Without low return store
19
10
9
8,000
720
Fred and Sally-Projected Operating Profit
Fred’s sister Sally was achieving better operating profits.
After-tax operating profits
($ thousands)
5000
Sally's
Shops
4000
Fred's
Hardware
3000
2000
1000
0
2000
2001
2002
Year
2003
2004
Fred and Sally-Projected Economic Profit
Operating Profit is not the best way to measure financial results
As shown the true financial results are measured from the ROIC and Economic Profit
Sally
ROIC
Sally
economic profit
Fred
Fred
2000
($ thousand)
(percent)
20
15
10
5
0
1500
1000
500
0
2000
2001
2002
Year
2003
2004
2000
2001
2002
Year
2003
2004
Fred’s New Concept of Fred’s Superhardware stores
Economic profit
5000
Old format
($ thousand)
4000
Converted
to new
format
3000
2000
1000
0
2004
2005
2006
2007
Year
2008
2009
2010
Discounted Cash Flows
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This is a way of collapsing the future performance of
the company into a single number.
Forecast future cash flow of the company and
discount it to the present at the same opportunity
cost of capital.
Economic profit and discounted cash flow (DCF) are
the same.
Discount economic profit to the amount of capital you
have invested today and you get DCF
Fred goes Public
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The financial market is different than the real market.
The financial market reacts to expectations
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These expectations are what investors want to be steady
Investors depend on their money to grow
The financial market is like betting on football
Stock prices go up with the growth of a company
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They exceed stock price with higher than expected economic
profit.
The stock price declines with less than expected economic
profit
Fred expands into related Formats
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Fred’s Furniture and Fred’s Garden Supplies
The financial market presents the demand for
accurate expectations of economic profits
Economic profits must be managed
Summary
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The accurate method of measuring financial results in
the real market is with Economic Profit
Use DCF to collapse future performance into a single
number
This enables you to forecast the future cash flow of
the company and discount it to the present at the
same opportunity cot of capital
In the financial market a company must forecast
future economic profits accurately to keep investors
happy and to continue investing