Return on Invested Capital
When executives, analysts, and investors assess a business’s potential to create value, they sometimes overlook the fundamental principle of value creation—namely, that the value of a business depends on its return on invested capital (ROIC) and growth. As Chapter 2 explains, the higher a company can raise its ROIC and the longer it can sustain a rate of ROIC greater than its cost of capital, the more value it will create. So being able to understand and predict what drives and sustains ROIC is critical to every strategic and investment decision.
Why do some companies develop and sustain much higher ROICs than others? Consider the difference in 2000 between eBay and Webvan, which were both newcomers at the height of the tech boom. In November 1999, eBay’s market capitalization was $23 billion, while Webvan’s was $8 billion. EBay continued to prosper, while Webvan soon disappeared. This is not so surprising when we look at the implications of their underlying strategies for their respective ROICs.
EBay’s core business is online auctions that collect a small amount of money for each transaction between a buyer and a seller. The business needs no inventories or accounts receivable and requires little invested capital. Once started, as more buyers use eBay it attracts more sellers, in turn attracting more buyers. In addition, the marginal cost of each additional buyer or seller is close to zero. Economists say that a business in a situation like eBay’s ...