468  Measuring Performance in Capital-Light Businesses
a distribution network, the entire outlay must be expensed immediately. In sectors 
such as pharmaceuticals, high technology, and branded consumer goods, failure 
to recognize such expenses as investments can lead to significantly underestimat-
ing a company’s invested capital and overstating its return on invested capital.
To get a more accurate measurement of ROIC,2 it’s best to capitalize out-
lays for intangible investments if they bring benefits over multiple years in 
the future rather than merely for the current year. Earnings in any given year 
are supported by not just that year’s R&D or brand advertising expenses, but 
instead by many prior years of these expenses. It has taken companies such 
as Coca-Cola and PepsiCo many decades and billions of dollars to build their 
global brand names. Pharmaceutical companies such as Pfizer, and high-tech 
companies such as Intel and ASML, had to invest in technology development 
projects over many years to build and sustain their current product offerings.
The economics of investments in intangible assets are very similar to those 
of investments in tangible assets. Their treatment in ROIC should therefore 
also be the same to ensure that it adequately reflects the internal rate of return 
(IRR), or true return, of the underlying investments.3 Failure to do so would 
lead to ROICs far above the true return of the business. Consider what would 
happen to ROIC if capital expenditures for net property, plant, and equipment 
(net PP&E) were not capitalized but were expensed instead.
In addition to improving the measurement of ROIC, capitalizing intan-
gible investments can reduce the manipulation of short-term profits. Under 
traditional accounting, a manager looking to meet short-term earnings targets 
can simply reduce R&D spending. With R&D capitalized, however, amortiza-
tion charges to earnings will remain almost unchanged in the short term. Cap-
italizing investments can also provide strategic insights. For example, many 
companies set R&D budgets at a fixed percentage of revenue. When combined 
with expensing R&D, this masks the change in performance resulting from 
any change in revenues, because the earnings margin remains unchanged. But 
when R&D is capitalized, amortization charges do not change with revenues, 
and the impact on performance is clearly reflected in earnings.
Example: Capitalizing R&D Expenses
As an illustration of capitalizing intangible investments and its impact on ROIC, 
Exhibit 24.1 presents the reorganized financial statements for PharmaCo. This fic-
tional company has experienced rapid growth over the past 25 years, reaching 
around $1.2 billion in revenues by 2020. The after-tax earnings margin is 11 percent 
of sales. R&D expenses, to renew the product pipeline, are at around 20 percent 
of sales. ROIC is at 33 percent, with revenues at three times invested capital as 
2 The same applies to return on capital measures such as cash flow return on investment (CFROI), as 
discussed in the following chapter.
3 To be truly “value based,” the measure for return on capital should reflect the internal rate of return 
(IRR) of the underlying business from the time investments are made until all the cash flows from that 
investment have been collected (see also Chapter 25).