November 13, 2005

Comparing performance when invested capital is low

Good article (free registration required) on mckinsey quarterly on how to evaluate performance, when the invested capital is low in a business (like IT services, FMCG, consulting services etc)

Some excerpts

A more useful way to measure performance is to divide annual economic profit by revenue.2 Grounded in the same logic as conventional ROIC and growth measures,3 this metric gives executives a clearer picture of absolute and relative value creation among companies, irrespective of a particular company's or business unit's absolute level of invested capital, which can distort more traditional metrics if it is very low or negative. As a result, executives are better able to evaluate the relative financial performance of businesses with different capital-investment strategies and to make sound judgments about where and how to spend investment dollars.

In application, this approach will vary from business to business, depending on what is defined as volume and margin. In a people business, such as accounting, the margin would likely best be broken down into the number of accountants multiplied by the economic profit per accountant. In a software business, however, it would be better calculated as the number of copies of software sold times the economic profit per copy of software; in this case, deriving the margin from the number of employees wouldn't make sense. But in all cases, this approach can provide a more nuanced understanding of performance across businesses or companies with divergent levels of capital intensity.

Equally important, economic profit divided by revenue avoids the pitfalls of ROICs that are extremely high or meaningless as a result of very low or negative invested capital. Economic profit, in contrast, is positive for companies with negative invested capital and positive posttax operating margins, so it creates a meaningful measure. It is also less sensitive to changes in invested capital. If the services business mentioned previously doubled its capital to $20 million, its ROIC would be halved. But its economic profit would change only slightly and economic profit divided by revenue hardly at all (to 6.8 percent, from 6.9 percent), thus more accurately reflecting how small an effect this shift in capital would have on the value of the business.4

my thoughts : The above metric is not sufficient to evaluate. I would still consider a low capital intensive business superior compared to a capital intensive one , even if the above ratio is low , as a low capital intensive business could have higher free cash flow (provided both have similar competitive advantages ) and hence could be worth more.
The above metric is good to look at, but i would not base my decision on it (or any other single metric)

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