ROIC and Growth as Primary Value Drivers, Not Earnings

Definition

ROIC (return on invested capital) and growth are the two fundamental levers that determine cash flow and thus shareholder value. ROIC measures what a company earns on the capital it deploys; growth measures how fast the capital base expands. Together, they determine how much cash a company generates relative to the capital required to support that generation. Accounting earnings growth, by contrast, can obscure the underlying drivers: two companies with identical earnings growth can have wildly different ROICs and therefore wildly different cash flows and value.

In the Book

Chapter 2 opens with a striking empirical finding: Walgreens and General Mills earned nearly identical shareholder returns from 1985 to 2012 (about 10 percent annually), despite Walgreens' after-tax operating profits growing 13 percent per year versus General Mills' 9 percent annually. Walgreens' profits in 2012 were 25 times larger than 1985; General Mills' were only 9 times larger. Yet the shareholders earned the same returns. Why? General Mills earned a 29 percent ROIC while Walgreens earned only 16 percent. General Mills' higher returns on capital generated equivalent value despite much lower growth.

Chapter 5 provides empirical validation across industries: "so-called growth stocks do not grow materially faster on average" but "do have higher ROICs." The median ROIC for value stocks is 15 percent; for growth stocks, 35 percent. Markets price companies based on ROIC and growth, not on earnings or earnings growth. A simple fundamental model based on ROIC, growth, and cost of capital explains stock market P/E ratios across five decades, through booms and busts. Exhibit 5.5 shows that industries with high market valuations (software, pharmaceuticals) have high ROICs; industries with low valuations (utilities, oil & gas) have low ROICs. The market sees through accounting earnings to the underlying economics.

Why It Matters

This principle forces managers to think operationally rather than cosmetically. It reveals that high-ROIC companies should invest for growth while low-ROIC companies should fix returns before growing. It also exposes the danger of earnings-focused management: you can grow earnings without growing value, and you can sacrifice enormous value to smooth quarterly earnings. The empirical validation—that markets price consistently on ROIC and growth—suggests managers should stop worrying about beating earnings targets and start focusing on the metrics that actually drive value: the returns on capital deployed, and the sustainable rate at which capital can be productively deployed.