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Return on Invested Capital

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 Why is ROIC Important?
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.

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 Sustainable Competitive Advantage

• The efficient use of capital will

improve short-term ROICs, but to Company Profitability: Industry Matters

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.

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 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:

Operating profit
ROIC  (1  Tax rate)
Invested capital

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

Operating profit per unit

ROIC  (1  Tax rate)
Invested capital per unit

• 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):

Price per unit - Cost per unit

ROIC  (1  Tax rate)
Invested capital per unit

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 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).

Example:
Quality: Customers willing to pay a
Price premium premium for a real or perceived difference
in quality over and above competing
products or services.

Better cost Cost: Innovative business method: Difficult-

Superior ROIC
structure to-copy business method that contrasts
with established industry practice

More efficient Scalable product/process: Ability to add

use of capital customers and capacity at negligible
marginal cost/capital.

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 Price Premiums
Price

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

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

examine five sources of 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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 Price Premiums
Price

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

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

examine five sources of 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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 Price Premiums
Price

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

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

examine five sources of 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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 Cost and Capital Advantages
Price

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

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

invested capital than competitors.

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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 Cost and Capital Advantages
Price

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

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

invested capital than competitors.

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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 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.

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.

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 ROIC Distribution

• The distribution is wide for all

Distribution of ROIC: Shifting to the Right
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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 Sustaining ROIC

• In this analysis, we measured the

Nonfinancial Companies: ROIC Decay Analysis
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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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.
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

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 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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