Understanding Return on Invested Capital

Over a long holding period, shareholder returns converge on the return the business earns on the capital it employs. Employed capital is measured both in the form of existing assets and incremental capital. Return on invested capital, as a metric, should help decide what should happen next: reinvest, distribute, or liquidate. Internal growth only creates value when the incremental dollar earns more than it could elsewhere. Managers who ignore that rule, especially once a business has hit its natural ceiling, destroy owner value even when revenue is still rising.

Economics is a distillation of the physics of business. You can argue with the laws, but the universe is built the way it is. And it just so happens that every business is subject to the same economic laws, relatively speaking.

Finance and accounting, like math in physics, are the language of the business world. Accounting describes what a firm did. Finance, and specifically the return on capital outlays, is the mechanism for comparing one use of money with another, inside the firm or outside it.

There are four immutable uses for how the money a company generates or has on its balance sheet can be used. Those are the only ways a firm’s capital can be deployed:

A manager or owner can:

(A) Invest internally

(B) Buy another company

(C) Distribute earnings to shareholders

(D) Pay down debt

Managers with a shareholder orientation are generally hired to serve the interests of all owners and are responsible for maximizing the value of the money invested by those owners.

Investors give management teams money and say, “Make money with this money by operating the business.”

The measure of the effectiveness of that manager and the assets they employ is the return on invested capital (ROIC).

ROIC should therefore govern every business expense and every capital outlay. The following is a proof of sorts for how that conclusion is reached.

Reduce any business to three parts: inputs, outputs, and a net effect.

Money goes into a business so that a good or service can be produced and then consumed. What remains is the net effect. In business terms, expenses are production and revenues are consumption. The net effect is a profit or a loss from the sale or internal consumption of what is produced.

A loss means the business and its owners have become the consumers of what was produced. A profit means managers have more money than they started with as a result of producing the good for more than the sum of the inputs.

As simply as it can be stated, a real return for shareholders is generated when one dollar is invested into the business and more than one dollar comes back to those investors. That excess, earnings, can be used to grow future earnings or it can be paid to owners, one of the four options presented earlier.

A perfect business therefore would need no additional capital from the investors and could grow revenues and earnings without growing expenses. Expenses would never rise, and revenues and profits would keep rising. Reality does not offer that for any business. No business like this exists. The best examples of businesses close to this reality, however, are companies with a high return on invested capital. These companies need little continual additional capital and have the ability to raise prices on their goods and services well above the cost of the inputs required to create them.

Return on capital measures how efficiently the firm turns the money it holds into additional profits in later years. A firm that can raise profitability without spending much more to produce, market, or sell, and without taking on considerable debt to grow, will earn a higher return on invested capital than a firm that needs the opposite.

The differences in economic characteristics among businesses have been defined well enough by others that they do not need to be repeated here. But, broadly speaking, companies fall into three return-on-invested-capital categories. John Huber’s concise 2016 article for Saber Capital Management sums this as follows:

1. Category #1: High ROIC, Low Capital Requirements, Exceptional Pricing Power

•        Profile: Massive initial returns on capital with very little extra money needed to grow.

•        Example: See’s Candies (60% initial pre-tax ROIC).

2. Category #2: Capital-Required Growth with Adequate/Good Returns

•        Profile: To grow larger, the business must spend heavily on assets (like physical equipment, simulators, or infrastructure), earning solid but moderate incremental returns.

•        Example: Regulated utilities or FlightSafety.

3. Category #3: High Capital Demand with Low or No Returns (“Gruesome Economics”)

•        Profile: Insatiable appetite for cash investment just to stay afloat, yielding poor or negative economic returns.

•        Example: Commercial airlines for most of history or virtually every restaurant ever.

Measurement of ROIC can be complicated by bad accounting, imprecise measurement, and fuzzy math. The component parts that go into measuring ROIC and operating a business tend to be imprecise and are often measurable only in hindsight. Aspects of marketing and recruiting are a clear case. How do you perfectly measure the ROI from market visibility or recruiting exceptional talent? To add to the complexity of measurement, businesses do not grow in straight lines, and they do not produce a steady profit every year forever.

In 2019, forty percent of all publicly listed companies did not turn a profit. Among the smallest eighty percent of those companies, persistent loss-makers—firms losing money for three years—have increased over the long term. Public-market data is more than sufficient to show that profitability, revenue, and operating margin can swing negative over long periods. This period of loss-making can be especially hard to measure when a business enters a new phase of its life cycle for one or many of its products due to changes in technology. In the late 1990s, many companies faced this challenge existentially. Retailers and distributors were being actively disrupted by the internet. The next phase distribution companies will face, which will muddy ROIC calculations, is coming with artificial intelligence—or, if you prefer, superintelligence.

Mice won’t grow to the size of elephants. Some businesses will never grow from small to large, or to a certain level of profitability for a variety of reasons. Observably, it is human nature to strive for more, more growth, more scale, more people. When management fails to realize that ROIC turns negative beyond a certain point, shareholder value is destroyed instead of preserved or created. Time and time again, management teams default to growth at all costs rather than growth at the rate of opportunity cost. In the worst cases, shareholders pay for that mentality and management is paid by it. Firms plateau or die. They reach the top of their market but then face a long decline from poor management of capital. Venture-backed firms regularly flame out as management uses growth at all costs to achieve first-mover advantages while failing to right-size unit economics and then stubbornly refuses to accept the natural zenith of a market or even to see that the market is subject to one.[G2]  Shareholder value and otherwise distributable profits are sacrificed like Aztec tributes in the process. Invariably, the employees who built the temples that become places of sacrifice similarly suffer from a poor allocation of their time and talent and leave when they recognize this, often creating a downward spiral affecting more than returns.

It is unreasonable, and silly, to assume that any investor, or any person inside of the firm, knows the future distributable cash flows of a business down to the penny. Investors therefore cannot hold managers fully accountable for what managers cannot control in absolute terms. But skill still matters.

So does the chance to widen the firm’s available options for investing money. The most skilled managers will find ways to maximize the opportunity cost of the firm, invest wisely, and reduce risk. Consistent performance in maximizing opportunity cost, even in temporarily lower-earnings environments, is a valid use of the firm’s capital. Repeatable results will generally follow if managers can remain disciplined while continuing to widen the opportunity cost of the firm. These processes should be made as repeatable as possible.

Return on invested capital should be held as the gold standard metric for investors and management teams when making dollar-based decisions. To explain ROIC as simply as possible, investors and managers can ask the following question:

Will the next dollar invested by the company earn a favorable return inside this business, or elsewhere?

For owner-operators who have hit the plateau where additional capital spent in the business earns a low return, they should focus on maximizing opportunity cost. Owners should look to reduce the risk to cash flows by hiring skilled managers who are skilled allocators of capital and talent and who can incorporate this type of thinking into decision-making.

An owner and a management team that actively measure return on invested capital will naturally find better uses for capital than their peers, all else being equal.

Investors evaluating new investments should factor into their valuation what the return on capital of the business will be over the near term and the long term—5, 10, and 15 years. Can the company and management team use its capital internally at high rates of return with little incremental capital? Can it compound that capital for a long time?

Charlie Munger put it this way:

“Over the long term it is hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years, you are not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns an 18% return on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with one hell of a result.”

Below are a few useful articles on this topic worth sharing with your management teams:

•        Forbes, “CEOs That Focus on ROIC Outperform”

•        Morningstar classroom note on return on invested capital

•        McKinsey, “A Long-Term Look at ROIC”

•        NYU Stern, Aswath Damodaran, “Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE)”

•        SBH All Cap Equity Research, “Return on Invested Capital”