The Key to Building a Valuable Business: ROIC Over Everything

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Most businesses chase revenue growth, but true value creation happens when Return on Invested Capital (ROIC) exceeds the Cost of Capital. If you’re not making more on your investments than what it costs to fund them, you’re destroying value.

Why ROIC Matters More Than Profit
 

A business isn’t valuable just because it generates cash flow. It must produce returns that justify the capital invested. Consider three scenarios where a company invests $10,000 with a cost of capital of 8%:

1. Value Destruction – Generates $500/year, worth only $6,250 in today’s dollars. Bad investment.

2. Neutral Value – Generates $800/year, worth exactly $10,000. No value created.

3. Value Creation – Generates $1,100/year, worth $13,750. Now you’re building wealth.

Positive cash flow alone isn’t enough—it must exceed your cost of capital to create value. 

Strategy’s Role in ROIC

So, how does strategy fit into this? A strong strategy helps a company earn high returns on invested capital. Michael Porter, a leading strategist, identified two key ways companies achieve competitive advantage:

1. Differentiation – Charging premium prices by offering something unique (e.g., Apple)

2. Cost Leadership – Producing at a lower cost than competitors (e.g., Walmart)

Breaking down ROIC:

ROIC = NOPAT/REVENUE X REVENUE/INVESTED CAPITAL

• NOPAT / Revenue → Measures profit margins (high margins suggest differentiation)

• Revenue / Invested Capital → Measures capital efficiency (high turnover suggests cost leadership)

If neither is high and ROIC is below your cost of capital, you’re stuck in the middle.

Applying This to Your Business

Want to know if your business is truly creating value? Here’s what to do:

1. Calculate Your ROIC

   • Find your Net Operating Profit After Tax (NOPAT) and express it as a percentage of revenue

   • Calculate your Invested Capital Turnover (Revenue ÷ Invested Capital)

2. Analyze Your Competitive Advantage

   • If NOPAT margin is high, you’re likely succeeding in differentiation

   • If capital turnover is high, you’re excelling in cost leadership

   • If neither is high—and ROIC is below your cost of capital—you might be stuck in the middle with no clear advantage

Profit Isn’t Enough