Valuations: Return on Invested Capital (ROIC)

One of the key drivers of value accretion is ROIC. Value is only created when a firm generates cash flows at rates of return which is greater than its cost of capital. Else value is destroyed. A derivative of this principle is that any firm activity which does not increase cash flows (at rates
greater than the cost of capital) does not increase value.

Value is more sensitive to ROICs than growth rates.

Different industries have different dynamics of ROIC. If ROIC is negative and the company grows its top line that actually results in value destruction. McKinsey did a study of 5000 companies from 1963 to 2007 of ROICs of various industries. I being an average investor would strictly avoid some of the industries. I have luckily done so.

Diagrams: Courtesy McKinsey


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