Fundamental Principles of Value Creation n Freds Hardware

Fundamental Principles of Value Creation n Fred’s Hardware Story n n n Small chain of hardware stores Superhardware stores Additional retail stores n n 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 ) ($thousands) Entire Company 18 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.

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

Fred’s New Concept of Fred’s Superhardware stores

Discounted Cash Flows n n 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 n n The financial market is different than the real market. The financial market reacts to expectations n n 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 n n 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 n n n 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 n n 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