Measuring return on capital is equivalent to measuring the value created or destroyed by a firm’s operations. If that return exceeds a certain rate, the firm has ‘created’ value; if it misses the target, value has been ‘destroyed’. In my previous article (The Treasurer, Issue 1 2025, p20-21), I looked at a very common metric, return on capital employed (ROCE), and concluded that it has some serious failings as a measure of value. In certain situations, it can decrease year on year, even when the firm is creating value.
The foundation of value creation lies with the strategy the firm adopts and the quality of management. Figure 1 illustrates a ‘hierarchy’ of value creation.
The second layer of the hierarchy is growth, which evidences demand, and return on capital. Return on capital is a function of how much more the output is worth compared with the input: in essence, the value-add from the activity. It is essential that growth is linked to return on capital: history is littered with the debris of firms ‘buying growth’ and destroying value.
The last layer of the hierarchy gets into the metrics and KPIs we all recognise and focus on, such as profit, free cash flow and earnings per share (EPS). These are really easy metrics to measure and are reported on consistently. But they reflect the hierarchy above them: value cascades down from the strategy and quality of management, which determines growth and higher returns on capital, and these are then reflected in better reported profit, EPS and cash flow.
No-one to date has developed a way of measuring return on capital effectively. The most common metric, ROCE, is not up to the job, as we discussed in the previous article. Convoluted processes such as ‘economic value added’ exist, but these are highly judgemental, complicated, and expensive to implement and explain. In addition, these alternatives don’t quite do the job – and this means the focus of the financial world is stuck on the bottom level of the value hierarchy, ie the simpler metrics that fall out of the layers above.
But there is a simple and easy way to measure returns on capital. To get to it, let’s go back to absolute first principles, the first thing we are taught when we learn about measuring value. The inputs into any discounted cash-flow model are simply these:
Theory says you can discount the cash flows at a target cost (or return) of capital to get either a positive value creative or negative, value destructive result. Alternatively you can work out the discount rate that produces a neutral result and this is known as the internal rate of return. This technique is embedded in financial theory and universally accepted.
Ideas about how to directly measure value within the firm were first touted in the academic world by Alfred Rappaport in 1981 but his approach never quite fully addressed the challenge and never took off. Having read his work I feel that his concept, along with those such as EVA, ROCE and their derivatives, all suffer from a reliance on too much complexity or faith in traditional accounting whose conventions differ from the economic approach we have walked through above.
So, let’s have a go ourselves at sourcing those two inputs required to measure value from a standard set of financial statements:
We have now defined the numerator (change in EBITDA less tax) and denominator (capital invested) for our own KPI from first principles. I have called this KPI incremental ROCE, or ‘iRoCE’.
Effectively, this KPI is a snapshot of the most recent incremental return on capital the firm or business unit has produced. It is the internal rate of return (IRR) for a discrete period and the trend when calculated on a rolling basis builds up a true picture of value performance. Let’s examine how this KPI stacks up against ROCE.
Figure 2 illustrates how our new iRoCE KPI is derived from some readily available financial information. iRoce returns a value of 11% by taking the incremental change in cash profit (effectively EBITDA less tax) of 110, and the actual capital spent of 1,000. This value is close to the true IRR from the investment.
ROCE, however, under these inputs, shows a deterioration of 1 percentage point, moving from 15% to 14%. This is not particularly informative, but worse than that, the results are highly contingent on several elements that are completely unrelated to the actual economics.
Table 1 demonstrates how dependent ROCE is on historic accounting treatments. The firm’s history, the extent to which it has built its business through substantial M&A, or grown organically, and even depreciation policies impact the output.
iRoCE, however, returns a consistent 11% value, because it is sourced from the changes to cash profit and the capital spent. These inputs into the iRoCE KPI are independent of accounting judgements, historic transactions and the effects of inflation.
I described iRoCE as ‘a game-changer’ and I’d like to finish by explaining why. iRoCE can be determined at practically any level within the firm, be that strategic business units, products, geographies – in fact, wherever incremental profit and the capital invested are known. The implication of this is that the firm can work out ‘true’ returns on capital being generated from all these areas of its business. This incredibly powerful insight can be used to set management targets and allocate capital strategically over time to maximise the value of the firm. But more than this, I hope you can appreciate iRoCE’s simplicity, its basis in theory that gives it true strength, the ease with which it can be implemented, and lastly the power of its applications.
iRoCE is part of a strategic value performance framework I have developed called CPInsight™ (Capital Performance Insight). Empirical testing shows performance under the framework correlates more strongly to changes in Enterprise Value than traditional accounting metrics such as earning per share.
Ben Walters is the former deputy group treasurer of Compass plc. Please contact him via LinkedIn if you are interested in exploring how to implement the CPInsight framework into your business and transforming the way you identify and optimise value.
This article first appeared in The Treasurer Issue 2, 2025