Summary  481
economic profit over revenues best reveals how ReturnCo performs relative to 
its peers in terms of value creation. As the exhibit shows, the increased capi-
tal efficiency is roughly offset by the discount provided: ReturnCo’s ratio of 
economic profit to revenues is very similar to those of its peers. At first sight, 
ReturnCo’s ROIC appeared superior, but a closer look has revealed that its 
value creation is in line with that of its peers.
In general, when you are comparing the performance of businesses with 
very different capital intensity and size, using economic profit over revenues 
provides the best insights into performance and value creation.
Summary
For most businesses, ROIC is a good measure of return on capital. However, 
for businesses that rely on significant investments in intangibles, such as R&D 
or brands, you should make some adjustments to ROIC to include the capital-
ized value of these resources. For businesses that use very little or no capital, 
economic profit is a better measure of value creation. To allow for comparison 
across businesses of different sizes, you can scale economic profit by revenues.

483
25
Alternative Ways to 
Measure Return on Capital
Valuations often assume that historical return on capital is a good starting 
point for projecting future returns as a company grows. But if historical return 
on capital is measured in a way that gives us no meaningful information about 
value creation, decisions about whether to continue investing in a business 
may be incorrect. 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. That’s not possible in practice, because we can’t wait 
until the end of every project to assess a company’s performance; a business 
is an accumulation of different investments made at different times. So we 
need a proxy that measures how much value a company has created in the 
recent past and that can help a company with the particularly important task 
of planning for the future.
Return on invested capital (ROIC), our primary measure of return on 
capital, correctly reflects value creation in most cases. But ROIC has some 
imperfections. For example, it doesn’t account for the age of assets or the ef-
fect that inflation has on its measurement. Analysts have therefore proposed 
alternatives to overcome some of ROIC’s weaknesses. One of these, cash flow 
return on investment (CFROI), is estimated from cash flows rather than from 
accounting measures. CFROI is the better measure of value creation in certain 
rare situations. This chapter explores the conditions under which ROIC accu-
rately reflects the true economic return on capital and when to consider a more 
complex CFROI measure. We then look at some other alternatives and explain 
why they are flawed measures of value creation.
As we compare these measures, note that all of them apply this impor-
tant principle: any measure of return on capital should be based on the 
amount invested, not the current market value of the company or its assets. 

484  Alternative Ways to Measure Return on Capital
Take, for example, the case where the fair value of an asset is based on 
the intrinsic, discounted-cash-flow (DCF) value of its future cash flows. By 
definition, the return on capital for the asset at its fair value does not pro-
vide any indication of an investment’s value creation in such assets. For a 
growing business, a return on capital measured against the DCF value will 
always be less than the cost of capital, because the DCF value reflects the 
value creation of future investments.
When ROIC Equals IRR
The simplest approach to measuring return on capital, which works well in 
most cases, is the one we use throughout this book: ROIC, or operating earn-
ings divided by the net book value of a company’s operating capital (pur-
chase cost less accumulated depreciation). To illustrate when ROIC accurately 
estimates the IRR of an asset and the business activities it supports, we will 
use a stylized example, shown in Exhibit 25.1. The initial investment is $100, 
and operating cash flows gradually decline over the asset’s five-year lifetime. 
With linear depreciation charges of $20, the operating profit is proportional 
to the net invested capital in each year, declining from $15 in the first year to 
$3 in the last. We define ROIC in a particular year as the operating profit for 
that year divided by the invested capital at the beginning of the year, net of 
accumulated depreciation (ignoring taxes for simplicity). In this example, the 
asset’s ROIC is constant over the asset’s lifetime at 15 percent.
EXHIBIT 25.1  Returns When Profits Are Proportional to Net Invested Capital
$
 
Individual asset
Year
Business of
five assets
 
0
1
2
3
4
5
Operating cash flow
(100)
35
32
29
26
23
145
Depreciation
(20)
(20)
(20)
(20)
(20)
(100)
Operating profit
15
12
9
6
3
45
 
Gross invested capital1
100
100
100
100
100
500
Cumulative depreciation1
–
(20)
(40)
(60)
(80)
(200)
Net invested capital1
100
80
60
40
20
300
IRR, %
15.0
15.0
Cash return on gross invested capital, %
35.0
32.0
29.0
26.0
23.0
29.0
Cash return on net invested capital, %
35.0
40.0
48.3
65.0
115.0
48.3
ROIC, %
15.0
15.0
15.0
15.0
15.0
15.0
CFROI, %
22.1
18.0
13.8
9.4
4.8
13.8
|
|
ROIC is constant over asset lifetime.
CFROI decreases over asset lifetime.
ROIC = IRR
CFROI < IRR
1 At beginning of year.