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Why return on capital could be the metric that best helps companies achieve higher returns.
Vincent Ryan, CFO Magazine
June 1, 2008
In their never-ending quest to drive shareholder value, CFOs have a bevy of favorite performance gauges to point them in the right direction. But do popular metrics such as return on equity (ROE) and return on net assets (RONA) truly focus CFOs on the correct strategies for boosting a company's value?
Devon Value Advisers, a New York–based management consulting and transaction advisory firm, respectfully suggests that U.S. companies may be relying on the wrong financial measures. Indeed, the established guides to profitability and higher returns are not the ones that actually juice market values, according to a statistical study by the firm. Return on equity, for example, predicts share prices with an average statistical accuracy of just 50 percent, the firm found, and return on net assets, only 30 percent (see "Tuning In to Shareholder Returns" at the end of this article).
Instead, the consultancy believes companies should revert to an old standby — operating return on capital (ROC) — because it more precisely explains a company's share price than any other metric. The Devon Value study, which used standard R-squared analysis, showed that ROC — operating profit generated divided by the capital required to produce it — predicted share price with an average statistical accuracy of 90 percent.
The link between ROC and shareholder value was evident in 53 nonfinancial industries over a 12-year period. Of the 53 industries, 27 substantially increased ROC — from 20 percent in 1995 to 38 percent in 2007, on average. That produced growth in total shareholder return (TSR), which includes share-price appreciation and dividends, of 12 percent per year. The other 26 industries that saw modest or negative change in their ROC achieved, on average, just 7 percent TSR over that period.
"Return on capital is the simplest, closest measure of what a company earned, how much capital it needed to earn that amount, and the ratio between those two things," says Walker Lewis, chairman of Devon Value.
What's the Attraction?
The reason ROC more closely correlates with shareholder return, says Devon Value, is that it measures returns with operating earnings before interest and tax, net working capital, and net fixed assets. By contrast, ROE and RONA include a number of items (balance-sheet cash, goodwill and intangibles, and other assets such as long-term investments) that may not be part of the company's investment in operating profits going forward. Operating ROC rewards efficient use of capital, such as better inventory and receivables management, rather than rewarding one-time, nonoperating boosts to cash earnings.
That may be the real value of ROC — not that it correlates with movements in share price (many experts, in fact, argue that it would have to incorporate prevailing market expectations to do so), but that it "focuses on controllable drivers of fundamental intrinsic value," says Justin Pettit, a partner at Booz Allen Hamilton. "This measure simultaneously captures improved income-statement profitability and balance-sheet efficiency. For value purists, it is in relative harmony with the signals we will get from a more comprehensive net-present-value analysis."
The least likable thing about ROC? With a ratio, "maximization may not equate to optimization," Pettit says. He cites the example of a basketball team that pays its players based on their shooting percentages. "Each player would make one layup, and then, having maximized their ratio, decline further opportunities to shoot," Pettit says. But "value is created in aggregate dollar terms, not percentage terms." Therefore, return-based metrics such as ROC should be evaluated in tandem with a dollar metric to balance efficiency gains with valuable growth.
Pick Your Spots
The companies employing ROC have used it to understand, on a relative basis, which individual units contribute the most value. David Devonshire, former CFO of Ingersoll Rand and Motorola, calculated ROC to predict the share-price impact of portfolio-rebalancing programs at both companies. The ROC analysis at Ingersoll Rand "resulted in a disposition of a business that was dragging down the value of the enterprise. The stock went up 50 percent," he adds. John Humphrey, CFO of Roper Industries, says growth in operating profitability has been a key to Roper's strategy for "paying" the premium for the more than 20 companies it has acquired since 2003. "Improvement in profitability (both GAAP ROC and cash profitability) was a key element enabling our acquisitions to create substantial shareholder value," Humphrey says.
The Devon Value metric keeps the focus on good versus bad revenue growth, whether organic or through M&A, explains Warren Knowlton, former CEO of Morgan Crucible and now CEO of Graham Packaging. "Growth is obviously critical in the long run, but companies with low operating return on capital need to earn the right to grow," he says. "At Morgan, we increased our share price by 10 times over three years while reducing revenues by more than 30 percent. The revenue we retained was both profitable and growing." Profitable and growing. A financial metric that steers CFOs toward that combination could be worth a look.
Vincent Ryan is a senior editor at CFO.