Chapter 4Return on Invested Capital

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Why is ROIC Important?

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An Introduction to ROIC:

• In 1999, eBay’s market capitalization was $23 billion, while Webvan’s was $8

billion. Both were high-flying Internet startups with little financial history, so why

such a difference in market values?

• The difference in market value can be traced to capital intensity:

– Webvan was an online grocery-delivery business and its business model

required substantial warehouses, trucks, and inventory.

– eBay’s featured an easily scalable online auction business model which

required no inventories or receivables and very little invested capital.

• Eventually, Webvan burned through its cash and eBay continued to prosper. We

can trace this difference to the increasing returns to scale that each company’s

business model exhibited—and this is the dimension that ROIC attempts to

capture.

Sustainable Competitive Advantage

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• The efficient use of capital will

improve short-term ROICs, but to

maintain long-term ROICs above the

cost of capital, the company also

needs a sustainable competitive

advantage.

• For instance, pharmaceutical

companies tend to have high ROICs

(ranging between 20-30% between

1998 and 2008) because cost of

production is low and barriers to

entry (R&D and patent protection)

are high.

Company Profitability: Industry Matters

A Deeper Look at ROIC

• Return on invested capital equals the company’s after-tax operating profit divided by

the amount of operating capital the company requires to run operations:

• Finally, separate operating profit into price minus cost. A superior ROIC results from

either a price premium relative to peers or a lower cost or capital per unit (or both):

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capitalInvested

profitOperating rate)Tax(1ROIC

unitper capitalInvested

unitper profit Operating rate)Tax(1ROIC

unitper capitalInvested

unitper Cost -unitper Price rate)Tax(1ROIC

• Divide both sides by the number of units the company produces:

Sources of Competitive Advantage

• As shown on the previous slide, A superior ROIC results from either a price premium

relative to peers, a better cost structure or less capital required per unit (or both).

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Superior ROIC

Price premium

Better cost structure

More efficient use of capital

Example:

Quality: Customers willing to pay a

premium for a real or perceived difference

in quality over and above competing

products or services.

Cost: Innovative business method: Difficult-

to-copy business method that contrasts

with established industry practice

Scalable product/process: Ability to add

customers and capacity at negligible

marginal cost/capital.

Price Premiums

1. Unique Products through Innovation: Innovative good and services yield high returns on

capital if they are protected by patents, difficult to copy, or both.

• Pharmaceutical companies typically gain patents on new products, giving them 20

years with a market monopoly.

• Apple’s iPod is an example of a non-patent protected product which is difficult to copy

because of its appealing design and branding, not necessarily its technology.

2. Real (or perceived) Quality: Quality refers to any real or perceived difference between one

product or service and another for which consumers are willing to pay a higher price.

• In the car business, for example, BMW enjoys a price premium because customers

perceive that its cars handle and drive better than comparable products that cost less.

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ROIC

Price

Cost

Capital

To sell a product at a price premium, a company must find a way

to differentiate its products from those of competitors. Let’s

examine five sources of price premiums:

Price Premiums

3. Brand: A factor highly correlated and difficult to distinguish with “Quality,” Brand is especially

important when no particular quality difference is present and customer loyalty to brands in a

particular industry allows companies to charge higher prices for their products.

• Strong brands allow cereal companies to earn ROIC of roughly 30%, while a lack of

brand strength relegates meat processors to an ROIC of 15%.

4. Customer Lock-In: Making the replacement costs expensive or impractical for consumers is

an ideal way to lock-in customers and keep ROIC high for a particular company.

• Doctors that train on certain equipment such as stents, they usually have no compelling

reason to go through the training process once more for a competitive product.

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ROIC

Price

Cost

Capital

To sell a product at a price premium, a company must find a way

to differentiate its products from those of competitors. Let’s

examine five sources of price premiums:

Price Premiums

5. Price Discipline: In commodities industries, the laws of supply and demand can drive

down prices and ROIC, but some industries are able to set prices (though it is illegal in

many instances), and this can create elevated ROIC levels.

• OPEC (Organization of Petroleum Exporting Countries) is the world’s largest and most

prominent cartel and is able to set prices on oil (though a free-rider threat exists as

there is tremendous incentive to lower prices and attract more sales).

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ROIC

Price

Cost

Capital

To sell a product at a price premium, a company must find a way

to differentiate its products from those of competitors. Let’s

examine five sources of price premiums:

Cost and Capital Advantages

1. Innovative Business Method includes a combination of a company’s production, logistics,

and pattern of interaction with customers.

• Dell’s unique and innovative method to sell directly to customers and keeping minimal

inventory by purchasing standardized parts from different suppliers and different times,

allowing it to outsell its competitors until the shift to notebook computers caused a

industry-wide shock

2. Unique Resources consists of the advantages proffered by access to something that

cannot be replicated, such as a geographic location or a mine of natural commodities.

• Take two nickel-mining companies, Norilsk Nickel, which produces nickel in northern

Siberia, and Vale, which produces nickel in Canada and Indonesia. The content of

precious metals (e.g., palladium) in Norilsk’s nickel ore is significantly higher than in

Vale’s. Norilsk gets not only nickel from its ore but also some high-priced palladium.

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ROIC

Price

Cost

Capital

Cost efficiency is the ability to sell products and services at a lower cost

than the competition. Capital efficiency is selling more products per dollar of

invested capital than competitors.

Cost and Capital Advantages

3. Economies of Scale refers to the notion that with greater size, economies are born (though

usually at the regional or even local level, not in the national or global market).

• Profitability of health insurers is driven by their ability to negotiation prices with providers,

usually doctors and hospitals (which tend to be local), and size is the key element in the

ability to negotiate successfully.

• For instance, anyone who wants to compete with UPS or FedEx must first pay the

enormous fixed expense of installing a nationwide network, then operate at a loss for

quite some time while drawing customers away from the incumbents.

4. Scalable Product Process represents the concept that supplying or serving additional

customers is extremely low cost. Many companies use information technology (IT) to

deliver such products and services in a scalable form. Because serving more customers is

at negligible cost, margins rise as sales rise—a huge boost for ROIC.

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ROIC

Price

Cost

Capital

Cost efficiency is the ability to sell products and services at a lower cost

than the competition. Capital efficiency is selling more products per dollar of

invested capital than competitors.

Sustainability

The longer a company can sustain a high ROIC, the more value a company will create.

Whether a company can sustain a given level of ROIC depends on the length of the life

cycles of its businesses and products, the length of time its competitive advantages can

persist, and its potential for renewing businesses and products.

• Length of Product Life Cycle. The longer the life cycle of a company’s businesses and products,

the better its chances of sustaining its ROIC.

• While Cheerios may not seem as exciting as an innovative, new technology, the culturally entrenched,

branded cereal is likely to have a market for far longer than any new gadget. Tastes change very slowly.

• Ease of Imitation. If the company cannot prevent competition from duplicating its business, high

ROIC will be short-lived, and the company’s value will diminish.

• When the cost improvement of self-service kiosks arose in the airline industry, it translated into directly lower prices for

consumers and little change in ROIC, because every airline had access to these improvements.

• Potential for Product Renewal. Consumer goods companies excel at using their brands to

launch new products: Think of Apple’s success with the iPod and iPhone, Bulgari moving into

fragrances, and Mars entering the ice cream business.

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An Empirical Analysis of ROIC

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Empirical Analysis of ROIC

• In this section, we present evidence on rates of ROIC for more than 5,000 U.S.-based

nonfinancial companies since 1963. Our results come from McKinsey & Company’s

Corporate Performance Center database. Key findings are as follows:

• Median ROIC between 1963 and 2008 remained relatively constant at 10%, but it did vary

dramatically across companies, with only half of the observed ROICs between 5% and 20%.

• Line of Business is a major driver for ROIC, as industries with sustainable competitive

advantages, such as patents and brands, have high median ROICs (15-20%), versus basic

industries (paper, utilities, and airlines) with low ROICs (5-10%).

• Variation within an Industry occurs, as the spread between the best and worst performers in

an industry can be quite significant.

• Rates of ROIC are fairly stable, as there is not much fluctuation among industry aggregate

ROIC rankings, and individual company ROICs gradually tend toward their industry medians

over time but are fairly persistent.

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ROIC: 1963-2008

• The aggregate median ROIC without goodwill over these years equals about 10

percent, with annual medians oscillating in a relatively tight range between 7 and 11

percent, except during the years between 2005 and 2008.

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U.S.-Based Nonfinancial Companies: ROIC, 1963–2008

A few comments:

• ROIC is directly correlated with overall

economy growth. Regressing median ROIC

against gross domestic product (GDP) showed

that a 100-basis-point increase in GDP growth

translated into a 20-basis-point increase in

median ROIC.

• Until about 2004, median ROICs were stable.

In recent years, however, a company had to

earn a return on capital near 20 percent to be

above the median, and a return above about

25 percent to be in the top quartile.

ROIC Distribution

• The distribution is wide for all

periods, with most companies

earning between 5 and 20 percent

ROIC over the past 45 years.

• However, there has been a recent

shift toward more companies

earning very high returns on capital.

• In the 1960s, only 1 percent of

companies earned returns greater

than 50 percent, whereas in the

early 2000s, 14 percent of

companies earned returns of that

magnitude.

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Distribution of ROIC: Shifting to the Right

Sustaining ROIC

• In this analysis, we measured the

sustainability of company ROICs by

forming portfolios of companies

earning a particular range of ROIC

in each year (e.g., above 20

percent) and then tracking the

median ROIC for each portfolio over

the following 15 years.

• Companies earning high returns

tend to see their ROIC fall gradually

over the succeeding 15 years, and

companies earning low returns tend

to see them rise over time.

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Nonfinancial Companies: ROIC Decay Analysis

ROIC Trends: Persistence of High-Performance

• The below chart shows that the best-performing companies tend not to have a full decay

of their ROIC levels to aggregate median levels. High-performing companies are in

general remarkably capable of sustaining a competitive advantage in their businesses

and/or finding new businesses where they continue or rebuild such advantages.

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Nonfinancial Companies: ROIC Decay Analysis

• The ROIC of both high and low performing companies tends to the median, but does not fully reach the median on either end

• This points to the fact that successful businesses can sustain competitive advantages in their businesses, though it also might mean that unsuccessful business struggle to ever establish any sort of competitive advantage

Summary

There are many lessons to learn about returns on invested capital.

1. These returns are driven by competitive advantages that enable companies to

realize price premiums, cost and capital efficiencies, or some combination of

these.

2. Industry structure is an important but not exclusive determinant of ROIC. Certain

industries are biased toward earning either high, medium, or low returns, but

there is still significant variation in the rates of return for individual companies

within each industry.

3. If a company finds a formula or strategy that earns an attractive ROIC, there is a

good chance it can sustain that attractive return over time and through changing

economic, industry, and company conditions—especially in the case of

industries that enjoy relatively long product life cycles.

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