“The CFROI measure was developed to minimize accounting distortions in measuring firms’ economic performance, particularly distortions related to inflation. A time series of CFROIs helps in forecasting a firm’s likely returns on future investments. The CFROI is best understood not as a stand‐alone performance metric, but as part of a valuation model.”
—Bartley J. Madden1
KEY LEARNING POINTS
- ROIC is influenced by asset age and can be increased by simply allowing assets to depreciate.
- CFROI is a comprehensive measure of operating performance. Accounting and inflationary distortions are reversed. Depreciating assets and non‐depreciating assets are separated. Asset life is an essential input.
- The calculation of CFROI requires four inputs: gross cash flow, inflation‐adjusted gross investment, non‐depreciating assets, and asset life. We show how each input is calculated using Amazon as an example.
- Investments in R&D and operating lease expenses should be capitalized to improve the understanding of a firm’s economics and enhance comparability to peers.
- Inflationary effects can be significant, particularly for firms with long‐life assets and countries with high inflation rates. CFROI is an inflation‐adjusted measure of profitability, which makes it possible to compare companies over time and across borders.
- An improved measure of profitability is beneficial when assessing the plausibility of profitability forecasts.