Fred then asked if he should try to maximize return on invested capital. One of his stores was earning only a 14 percent return on invested capital and if he closed it, he could increase average return on invested capital. We told him that what he should care about is not the ROIC itself, but the combination of ROIC (versus cost of capital) and the amount of capital, expressed as economic profit. We showed him a simple example (Exhibit 3.1).

Economic profit can be expressed as the spread between ROIC less the cost of capital, multiplied by the amount of invested capital. In Fred's case, economic profit was $800,000. If he closed down his low returning store, average ROIC would increase, but economic profit would decline. Even though the store earns a lower ROIC than the other stores, it still earns more than its cost of capital. The objective is to maximize economic profit over the long-term, not ROIC. Fred was convinced. He set out to maximize economic profit.

Almost immediately, Fred came back very unhappy. His sister Sally, who owned Sally's Stores, had just told him about her aggressive expansion plans. Exhibit 3.2 shows the projected growth of Sally's Stores' operating profit next to Fred's. As you can see, Sally's operating profit was projected to grow much faster. Fred didn't like the idea of his sister bettering him.

Exhibit 3.2 Fred and Sally—Projected Operating Profit

Exhibit 3.3 Fred and Sally—Projected Economic Profit

Wait a minute, we said. How is Sally getting all that growth? What about her economic profit? Fred went back to check and came back with Exhibit 3.3. Yes, indeed, the way Sally was achieving her growth was by investing lots of capital. Her company's ROIC was declining significantly, leading to a decrease in economic profit despite the growth in operating profit. Fred was relieved and went off to explain it all to Sally.

Fred's New Concept

Fred was happy with the economic profit framework for a number of years. Then he came back to us. He wanted to develop a new concept called Fred's Superhardware. But when he looked at the projected results (he now had a financial analysis department), he found that economic profit would decline in the next few years if he converted his stores to the new format because of the new capital investment required (Exhibit 3.4). After four years, economic profit would be greater, but he didn't know how to trade off the short-term decline in economic profit against the long-term improvement.

We said, yes, Fred, you're right. You need some more sophisticated financial tools. We were trying to keep it simple. But now Fred was faced with a decision where the straightforward rule of increasing or maximizing economic profit doesn't offer a clear answer. You need discounted cash flows (DCF), also known as present value.

Fred said that he knew about DCF. This is a way of collapsing the future performance of the company into a single number. You forecast the future cash flow of the company and discount it to the present at the same opportunity cost of capital that we discussed above. We helped Fred apply DCF to his new store concept. We discounted the projected cash flows at 10 percent.

Exhibit 3.4 Fred's New Concept

Exhibit 3.4 Fred's New Concept

The DCF value of his company without the new concept was $53 million. With the new concept, the DCF value increased to $62 million. He was relieved that he could pursue the new concept.

But, said Fred, what is confusing to me is when do I use economic profit and when do I use DCF? And why aren't they the same? Good question, we said. In fact, they are the same. Let's discount the future economic profit at the same cost of capital. If we add the discounted Exhibit 3.5 Equivalence of DCF and Economic Profit Valuation

economic profit to the amount of capital you have invested today you get the same result as the DCF approach (exactly, to the penny, not just an approximation) (Exhibit 3.5).1

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