For Chief Financial Officers (CFOs) who track Return on Invested Capital (ROIC), it is one of the most important KPIs in their toolbox. But for many other finance professionals, the metric is perceived as optional.
Jack McCullough, president of the CFO Leadership Council, thinks there are a few reasons for the difference in opinion — starting with how you define ROIC. “Perhaps, finance leaders can't agree on what it means”, says McCullough.
"In the simplest terms, [ROIC] is a net operating profit after taxes, divided by invested capital, long-term debt, plus equity — and, some people say, minus cash," McCullough said. "It's similar to ROI, but the nuance is that ROIC includes debt, while ROI is more useful for a particular project."
But how you view the utility of the metric might also depend on where you sit. If you're on the investor side, few metrics can tell you as much about how well the company manages its business. But if you're on the executive side, especially if you're focused on the here-and-now, the perspective it offers might be too long-term.
"Investors like it mainly because it's strategic, and it's a long-term investment tool," McCullough said. Finance people who don't track ROIC might instead focus on Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). But this switch poses a problem: in focusing on EBITDA, executives tend to sacrifice the long-term to improve the current quarter's numbers.
"If you're only focused on what's going to happen in the next 90 days, that's understandable, but it's a dumb way to run a company," McCullough said. "ROIC is a vastly superior way to measure long-term success than EBITDA, which is just short term."
ROIC is more commonly tracked among larger, more established companies, Jason Maynard, senior vice president of global field operations at Oracle NetSuite, says. "I don't see smaller companies tracking it that closely; small family-owned businesses especially."
But when it comes to explosive growth and profitability, ROIC becomes increasingly significant for companies of all sizes.
"ROIC comes into play more at venture-or private equity-backed companies," Maynard said. "But oftentimes, these companies are still in high-growth mode, still trying, in many cases, to invest in the business. They're focused more on optimizing cash flow; when you grow, and have to make more sophisticated decisions, ROIC becomes more useful."
One possible reason investors tend to think in ROIC terms more than executives has to do with compensation; executive earnings and bonuses are tied to accounting earnings, for the most part, including EBITDA and net income, said McCullough. "But I'm not aware of a single company in which executive earnings are tied to ROIC, so it's not going to be the focus."
Focusing on ROIC is especially critical in a down market, he says, more so than an up market, because of its nature as a long-term metric. Mistakes can be forgiven in an upmarket that can't be in a down market.
"So, if you're a CFO and you dramatically overpay for something, the market almost doesn't care. But if your company stock isn't growing, you'll get punished for bad acquisitions."
McCullough names one company that has performed well because of its ROIC focus: Domino's Pizza, under the leadership of CEO Jeff Lawrence and his attention to long-term investments.
Domino's online order tracker was revolutionary for its time, preceding the mobile app revolution. But this long-term vision was not prudent in the short term. "Look at their stock since the IPO; it's outperformed Facebook and Apple," McCullough says.
McCullough also names GM, which has recognized that "green" cars are a growth segment and the company has subsequently invested heavily in it. "That's how you improve your ROIC: figure out what's going to work in the future, and invest there, rather than just invest in what's profitable right now," he said.
"It's hard to do, but it's critical,'" he said.
Jason Cherubini, co-founder and acting CFO-COO of Dawn's Light Media, says ROIC is a vital KPI, "along with payback period and risk valuation," he says.
Cherubini breaks ROIC into Return on Equity (ROE), which is how much of the company's cash needs go into a project, and Return on Assets (ROA), which is how much total investment, including any debt they might be able to take on for a project.
Tracking ROIC is important across industries, but doesn't necessarily have to do with day-to-day operations; it has more to do with capital budgeting, Cherubini says. "When the CFO is looking at the 5-year or 10-year investment plans, they're really looking at capital, and where it should be allocated."
Cherubini has also consistently focused on differentiating between expected returns and potential downsides and upsides of returns.
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