Measuring the performance and value creation of capital-light businesses
McKinsey Strategy & Corporate Finance
Accelerating sustainable and inclusive growth through bold strategies.
By Marc Goedhart , Vartika Gupta, CFA , David Kohn , Tim Koller , and Werner Rehm
Business leaders can get tripped up when they are evaluating businesses with low or negative invested capital—whether they are looking at their own businesses or trying to benchmark the performance of target companies.
You see this a lot in the software, IT, and professional-services sectors: leaders fall back on ROIC as a key metric in their assessments, but given the small capital base in many companies in these industries even modest changes can create large swings in ROIC, which renders this metric less meaningful than others.
Consider the situation for a hypothetical company that trades in plumbing supplies and tools. TradeCo’s offices and warehouse are in a low-cost location, and its inventory is low. Most of its supplies and tools are purchased on customer order, and because TradeCo pays its suppliers after customers pay off their invoices, the company’s working capital is negative. TradeCo’s revenues, earnings, and free cash flow are relatively stable over a five-year period, but its ROIC fluctuates, and in some years ROIC may be unmeasurable given that the company’s invested capital is negative (Table 1).
For TradeCo and others evaluating capital-light businesses, it may be better to use economic profit (EP) to benchmark performance and value creation. In contrast to the movements in ROIC, EP generally remains stable over time. Minor improvements in working capital led to an increase in ROIC from 2019 to 2020, for instance, but TradeCo’s earnings dropped during that same period, pushing down EP and value creation.
Even when evaluating capital-intensive businesses, leaders may want to put ROIC in perspective. Consider two companies, InhouseCo and ContractCo (Table 2), which are identical with one exception: ContractCo has outsourced all its production to a third party. It has no net property, plant, and equipment (PP&E) and no depreciation charges, but it has higher operating costs compared with InhouseCo.
Although ContractCo’s earnings are lower than InhouseCo’s, its ROIC is more than five times larger because it no longer needs PP&E. But ContractCo is not creating more value in its business than InhouseCo. In fact, as a look at economic profit indicates, the two companies’ value creation is identical. Making any decisions based solely on ROIC could be misleading.
In most cases, ROIC is useful for assessing performance. But for those businesses where there is limited or no capital, EP is a better metric to use.
Group CFO | Corporate Finance | Ex-Founder | China / APAC | INSEAD | MFin, MSc, CFA, CMA, FMVA, BIDA
2 个月I tend to agree with the principle. It's however important to note that if the Cost of Capital were anything else but 7.5%, the conclusion of the second the last paragraph would not hold true. E.g. If this company were a Private Company with limited Debt, its Cost of Capital should have been surely more than 9% (~fully diversified stock market), perhaps 15% (?), causing the Economic Profits from each company to differ significantly and causing ContractCo, thanks to its "ROIC > WACC", to still generate Economic Profits, whereas InhouseCo because "ROIC < WACC" would not.
VP Sales in Machinery Aftermarket | Bridging Big Picture with Pragmatic Execution
2 个月Valid observations. In the end pure maths sensitivity analysis.