Most corporate CEOs don’t have their eyes on the real economic prize as they oversee daily operations and plan for the future.
According to the Harvard Business Review, return on capital just isn’t on most CEOs’ radars, but it should be.
Return on capital is the major component of value creation (or destruction) as identified by Nobel prizewinners Franco Modigliani and Merton Miller more than a half century ago.
Return on capital is a profitability marker that measures the amount of return an investment generates for bond or stockholders. Essentially, it indicates just how effective a company happens to be at turning capital into real earnings for investors.
While return on capital demonstrates how well or how poorly a company is at making money, only about five of 100 CEOs on Harvard Business Review’s 2014 list of best-performing CEOs mention “return on capital” on their official biographies.
None of the five are at the helm of companies listed on the Down Jones Industrial Average or the EuroStoxx50, the review points out.
Why It Matters
While earning pure profits can bolster a company’s bottom line, it is the return on investment measure that really adds up to earnings for shareholders.
A 2012 McKinsey Report, for example, demonstrated that over a 15-year period companies that were able to shift more than 56% of their capital across their business units during the period were able to deliver an annual return to shareholders that measured about a third higher than companies that allocated the same amount of capital per unit as the year prior.
How to Increase Returns
A return on investment capital (ROIC) can be earned in one of two ways:
- Improving operating profit by increasing revenues or cutting costs
- Investing capital more wisely so those investments can grow
While both steps can improve overall returns, Harvard Business Review indicates that smarter investment decisions provide the most leverage over the long haul. Cost-cutting and profit increases are tried and tested in low-growth economics though.
Why ROIC Isn’t A Bigger Concern
Harvard Business Review dove into the resumes of current CEOs to search for an answer as to why ROIC isn’t a bigger concern on their radars and found that many may simply lack the skills necessary for investment analysis.
It estimates that only half of the CEOs of Dow Jones Index companies have experience in corporate strategy and finance.
In Europe, the number falls to about 32% of CEOs at the helms of EuroStoxx50 companies. What’s more, a 2013 McKinsey study showed that only 16% of board members understood just how it was their firms created value.
What it all adds up to, Harvard asserts, is a need for boards to look more carefully at CEO candidates before making a final appointments. Those that are serious about creating value should delve deep into candidate skills and may want to seek those with experience in private equity and investment analysis, the publication asserted.
