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:
ROIC = (1- Tax Rate)
Operating Profit
Invested Capital
• Divide both sides by the number of units the company produces:
ROIC = (1- Tax Rate)
Operating Profit per unit
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 of capital per unit (or both):
ROIC = (1- Tax Rate)
Price per unit – Cost per unit
Invested Capital per unit
0
Generating ROIC through Price Premiums
To sell a product at a price premium, a company must find a way to
differentiate its products from those of competitors. Let’s consider five
sources of price premiums:
1.Unique Products through Innovation: Innovative goods 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 that 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.
1
Price Premium Advantages: Strategy-Side
3. Brand: A factor highly correlated and difficult to distinguish from 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 percent, while a lack of brand
strength relegates meat processors to an ROIC of 15 percent.
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 who train on certain equipment, such as stents, usually have no compelling reason to go through
the training process once more for a competitive product.
5. Rational 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).
2
Driving ROIC through Cost and Capital Advantages
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.
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 keep minimal inventory by
purchasing standardized parts from different suppliers at different times allowed it to outsell its
competitors until the shift to notebook computers caused an industry-wide shock.
Unique Resources consist of the advantages proffered by access to something
that cannot be replicated, such as a geographic location or a mine of natural
commodities.
3
Cost and Capital Efficiency Advantages: Scalability
Economy of Scale refers to the notion that with greater size, cost savings are
born (though usually at the regional or even local level, not in the national
or global market).
• Size plays the role of a barrier to entry; for example, any competitor to FedEx or UPS must pay the
enormous fixed cost of building a nationwide network.
• Profitability of health insurers is driven by their ability to negotiate prices with providers, usually
doctors and hospitals (which tend to be local), and size is the key element in the ability to negotiate
successfully.
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 done at negligible cost,
margins rise as sales rise—a huge boost for ROIC.
4
ROIC Sustainability
• The longer a company can sustain a high ROIC, the more value a company will create.
• Length of Product Life Cycle directly affects the ability of a company to prolong its high
ROIC benefits.
• Microsoft and its Windows operating system, which has persisted for over a decade without
stop, shows that a customer lock-in on a long product life cycle can have monumental effects.
• Persistence of Competitive Advantage means that for a company that cannot prevent
competition from duplicating its business practices, the ROIC gains will be short-lived.
• When the cost improvement of self-service kiosks arose in the airline industry, it translated into
directly lower prices for consumers and no ROIC change because every airline had access to
these improvements.
• Potential for Product Renewal is important because as product life cycles and ROICs
decline, entry into new businesses or renewing existing businesses allows companies to
revive their ROIC levels.
5
Empirical Analysis of ROIC
6
ROIC FOR NONFINANCIAL COMPANIES
Percent
Annual ROIC without goodwill
Average
15.3
9.0
5.0
Years
Annual ROIC with goodwill
13.6
8.3
4.7
Years
Source: Compustat, McKinsey & Company’s corporate performance database
ROIC DISTRIBUTION FOR NONFINANCIAL COMPANIES
Annual ROIC without goodwill, 1963-2003
Approximately 50% of the sample
within ROIC range of 5-15%
18
16
Percent of sample
14
12
10
8
6
4
2
0
ROIC
<-10.0 -5.0
Percent of
observations 5
below ROIC
level
7
0.0
2.5
5.0
7.5
10.0
12.5
15.0
17.5
20.0
22.5
25.0
30.0
35.0
40.0 >40.0
11
15
25
42
56
66
74
80
84
87
89
92
94
95
84% of the sample
had ROIC below 20%
Source: Compustat, McKinsey & Company’s corporate performance database
100
ROIC BY INDUSTRY GROUP*
Percent
Annual ROIC without goodwill**
1963-2003
1994-2003
Pharmaceuticals and biotechnology
18.4
Household and personal products
15.2
Software and services
15.0
Media
14.7
Commercial services and supplies
21.8
18.8
18.1
14.3
12.8
Semiconductors and semiconductor equipment
13.2
11.9
Health care equipment and services
11.3
Food, beverage, and tobacco
11.0
12.4
14.8
11.9
Hotels, restaurants, and leisure
10.3
Technology hardware, and equipment
10.3
10.3
Automobiles and components
9.9
10.5
Capital goods
9.9
Food and staples retailing
9.6
Consumer durables and apparel
9.5
9.2
11.8
9.6
10.8
Retailing
9.0
9.5
Total sample
9.0
9.5
8.4
Materials
Energy
7.7
7.9
7.6
Transportation
6.9
Telecommunication services
6.5
5.7
Utilities
6.2
6.1
* Based on S&P Global industry classification standard, excluding financial companies
** Average of annual medians
Source: Compustat; McKinsey & Company’s corporate performance database
7.6
ROIC SEGMENTED BY SIZE AND GROWTH
Annual ROIC without goodwill, 1963-2003
Percent
Revenues
5001,0001,000 M 2,500 M >2,500 M
<0%
3.3
5.2
6.0
6.5
7.0
0-5%
8.0
7.7
8.0
8.1
9.1
5-10%
8.9
9.3
9.6
9.5
10.3
10-15%
10.8
10.9
11.2
10.9
11.8
15-20%
11.9
11.1
11.7
11.5
11.9
>20%
12.4
11.9
11.8
11.8
11.6
No clear relation between size
and performance
Source: Compustat, McKinsey & Company’s corporate performance database
ROIC increases with
higher growth rate
3-year real growth rate
200<200 M 500 M
ROIC DECAY ANALYSIS: NONFINANCIAL COMPANIES
Median ROIC of portfolio*
Percent
ROIC
Percent
>20
15-20
10-15
5-10
<5
Number of years following portfolio formation
* At year 0, companies are grouped into one of 5 portfolios, based on ROIC
Source: Compustat; McKinsey & Company’s corporate performance database
ROIC DECAY ANALYSIS: CONSUMER STAPLES
Median ROIC of portfolio*
Percent
ROIC
Percent
>20
15-20
10-15
5-10
<5
Number of years following portfolio formation
* At year 0, companies are grouped into one of 5 portfolios, based on ROIC
Source: Compustat; McKinsey & Company’s corporate performance database
ROIC TRANSITION PROBABILITY, 1994-2003
Percent, 3-year average of ROIC without goodwill
Total
ROIC in 2003
ROIC
in 1994 <5
<5
10-15
43
5-10
10-15
5-10
28
31
15-20
18
>20
19
12
40
21
15-20
6
17
25
19
5
>20
7
25
20
13
Source: Compustat; McKinsey & Company’s corporate performance database
100
11
100
6
11
17
13
100
18
100
25
50
100