Return on Invested Capital: Best Measure of Company Profitability



Return on Invested Capital (ROIC) is the most important metric for measuring the profitability of a company. Discussion includes the implementation of ROIC …

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3 Replies to “Return on Invested Capital: Best Measure of Company Profitability”

  1. Article October 2005
    Comparing performance when invested capital is low
    By Mikel Dodd and Werner Rehm
    https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/comparing-performance-when-invested-capital-is-low

    Exhibit 2
    Measuring value among business units—return on invested capital vs. economic profit
    https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights/Comparing%20performance%20when%20invested%20capital%20is%20low/SVGZ%20035_Comparing_performance_when_invested_capital_is_low_Exh_2.ashx

    '…Using these data, the return on capital for the software business is a negative 700 percent while the ROIC of the services business is a positive 700 percent, even though the actual difference in the invested capital of the two units is only 2 percent of revenue. The traditional business has a 30 percent ROIC. A conventional evaluation of performance would compare the two newer businesses on the basis of their margins (because their capital is so small as to be deemed meaningless) and scold the traditional business for its high capital intensity.

    That kind of approach can lead to serious misjudgments of the value created by the three units and to the misallocation of resources among them—as indicated by the fact that the traditional business has the highest value of the group, even though it has the lowest growth rate (Exhibit 2, part 2). How can this result be reconciled with the observed returns on capital in order to compare the true fundamental performance of the three units? It turns out that in this case, ROIC tracks the creation of value much less accurately than does economic profit divided by revenue. According to that measure, the economic performance of the three units is remarkably similar. All are creating value in absolute terms (all the ratios are positive), and they are creating value at a similar rate, with the traditional business slightly ahead.

    Equally important, economic profit divided by revenue avoids the pitfalls of ROICs that are extremely high or meaningless as a result of very low or negative invested capital. Economic profit, in contrast, is positive for companies with negative invested capital and positive posttax operating margins, so it creates a meaningful measure. It is also less sensitive to changes in invested capital. If the services business mentioned previously doubled its capital to $20 million, its ROIC would be halved. But its economic profit would change only slightly and economic profit divided by revenue hardly at all (to 6.8 percent, from 6.9 percent), thus more accurately reflecting how small an effect this shift in capital would have on the value of the business.4
    Using the same approach, consider again attempts to compare the operating performance of the US high-tech manufacturer with that of its direct competitor (Exhibit 3). Owing to the high-tech company’s negative invested capital (a result of the outsourcing strategy), ROIC comparisons were meaningless. Margin comparisons were also tricky; a company that outsources would be expected to have lower margins than one that holds on to all parts of the value chain. But an analysis using economic profit divided by revenue made it clear that the outsourcing strategy as implemented wasn’t as successful as had been hoped; the high-tech company was still generating less value per unit of revenue than its competitor…."

  2. Article October 2005
    Comparing performance when invested capital is low
    By Mikel Dodd and Werner Rehm
    https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/comparing-performance-when-invested-capital-is-low

    Exhibit 1
    Capital requirements vary across businesses.
    https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights/Comparing%20performance%20when%20invested%20capital%20is%20low/SVGZ%20035_Comparing_performance_when_invested_capital_is_low_Exh_1.ashx

    "……Same company, different economics
    A large European industrial conglomerate provides an example of the difficulties of using ROIC to compare business units with different levels of capital intensity. The company’s executive board decided to take advantage of a trend in traditional industries toward adopting the next generation of process automation software and services by launching a business unit that exclusively offered software solutions based on standard off-the-shelf hardware. The new business naturally had a low level of invested capital, since its assets were essentially people and no manufacturing was involved. The willingness of customers to pay in advance for software development moved the level of operating invested capital below zero….."

    "….. US high-tech manufacturer that pursued an aggressive facility-outsourcing strategy combined with a just-in-time inventory system eventually drove its invested capital below zero. As a result, the company’s ROIC was negative and therefore meaningless. A direct competitor also acted to improve its efficiency but kept its manufacturing assets in house. This decision left it with significantly higher levels of invested capital but also with higher margins. It thus had a substantial positive—and meaningful—ROIC, which made apples-to-apples comparisons between the two companies impossible. Furthermore, the ROIC of the first company fluctuated wildly, as minor changes in its invested capital sharply altered the results of the ROIC calculations….."

    "…..A different measure
    To understand how a metric based on economic profit and revenue can eliminate such distortions in measuring value, consider a hypothetical company with three business units, each with $1 billion in revenue (Exhibit 2, part 1). Two newer business units—a software business and a services business—have very low or negative invested capital. The company’s more asset-heavy traditional business can extract a profit margin of 12 percent (compared with 7 percent for the other units) because it doesn’t outsource any parts of the value chain and has an established, captive customer base that faces high switching costs. It is growing more slowly, however—by 4.5 percent a year, compared with 6 percent for the new businesses…."

    Exhibit 2
    Measuring value among business units—return on invested capital vs. economic profit
    https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights/Comparing%20performance%20when%20invested%20capital%20is%20low/SVGZ%20035_Comparing_performance_when_invested_capital_is_low_Exh_2.ashx

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