Choosing between ROIC and CFROI  487 well—an investment outlay of $50. The IRR on that incremental investment is now equal to its CFROI of 13.8 percent. Note that the business ROIC of 15 per- cent overestimates the IRR in this case. In general, the business (or company) CFROI is exactly equal to the IRR of new investments if operating cash flows for the business are proportional to gross invested capital. Choosing between ROIC and CFROI To understand when to use ROIC and when to use CFROI, let’s now compare the two examples in Exhibits 25.1 and 25.2 in more detail. Note that the busi- nesses (not the assets) in both examples have identical ROIC, CFROI, earnings (operating profit), operating cash flow, and invested capital. Nevertheless, the underlying economics and value creation are quite different, as is the “right” measure for return on capital.3 For the example in Exhibit 25.1, ROIC is the right measure of return on capital for the asset and the business, equaling the IRR of 15 percent. The rea- son: the cash flow pattern over the lifetime of the asset leads to earnings that are proportional to net invested capital in each year. At the asset level, this results in a constant ROIC and a changing CFROI over the asset’s lifetime. At the business level, it implies that aggregate earnings and net invested capital grow in line with each other (assuming that growth comes only from adding more assets to the business).4 For the example in Exhibit 25.2, CFROI is the right measure and equal to the IRR of 13.8 percent, because now the operating cash flows are proportional to gross invested capital. At the asset level, CFROI is constant over the asset’s lifetime, and ROIC continues to increase as the capital base is depreciated. For the business, this means that aggregate operating cash flows and gross invested capital grow in line with each other. These two examples illustrate that there is no single right measure of return on capital. Depending on the earnings and cash flow pattern of the investment projects underlying a business, ROIC or CFROI can be equal to IRR—in theory. The fact that CFROI is calculated based on cash components does not mean it is always superior to the accounting-based ROIC. Theoretical Trade-Offs Although the examples were stylized, it is possible to derive general insights about the theoretical trade-offs between ROIC and CFROI. CFROI is more 3 Even though the cumulative cash flows over the lifetime of the underlying assets are equal, the assets shown in Exhibit 25.1 generate higher cash flows earlier in their lifetimes. As a result, the value creation is higher, as reflected in the assets’ IRR of 15.0 percent, versus 13.8 percent for the assets in Exhibit 25.2. 4 Note that this is in fact the economic model that we assumed in deriving the ROIC-growth value driver formula in Chapter 3. 488  Alternative Ways to Measure Return on Capital appropriate in businesses where investments are very lumpy. As two extreme examples, think of infrastructure projects or hydroelectric power plants. These require very substantial up-front investments that generate relatively stable cash flows without significant investments in maintenance or overhauling over many years or even decades. Although accounting conventions may re- quire that the assets be depreciated, their net capital base has little bearing on the capacity to generate cash flows. ROIC often rises to levels that are unre- lated to the project’s economic return (IRR), but CFROI will be much closer to the IRR because the operating cash flows are very stable. In contrast, ROIC is likely to be a better estimate of the underlying IRR in businesses where investments occur in a more regular and smoother pattern because they are needed to support the earnings. As an example, think of re- tail supermarkets or a manufacturing company with many plants and pieces of equipment. These businesses require regular investments as management maintains, upgrades, and renews product lines and shop formats. In the peri- ods between making such investments, pricing and earnings are likely to face pressure from competition with newer products or formats. As a result, the de- preciated capital base is a reasonable approximation of the ability to generate earnings, making ROIC a better estimate of underlying IRR. In our experience, this is the case for most companies: maintenance and replacement investments are required on an ongoing basis to support the operating earnings. Practical Considerations Apart from these theoretical considerations, some practical trade-offs exist between ROIC and CFROI. First, it is easier to estimate ROIC and its com- ponents, such as operating earnings and book value of invested capital, from standard financial reporting statements with some reorganization and adjust- ments (as described in Chapter 11). Once you have the components, ROIC is a straightforward ratio that most managers are familiar with. In contrast, CFROI requires a far more complex, iterative calculation that is not transpar- ent to many managers.5 Because of the way CFROI is defined and calculated, interpreting it also is less straightforward than in the case of ROIC. For example, it follows that to double the ROIC, managers would need to double their profit margin or double their capital turnover. With this logic, any reductions in inventory lev- els or costs of raw materials, for example, translate easily into ROIC improve- ments. In contrast, doubling capital turnover does not necessarily translate to doubling CFROI, because it is not a simple ratio. For the same reason, deriving 5 For this reason, practitioners have developed approximations of CFROI that are based on less complex calculations. See, for example, A. Damodaran, Investment Valuation, 2nd ed. (New York: John Wiley & Sons, 2002), chap. 32.