The one thing businesses should be measuring (but often aren’t)
August 01, 2017
Companies need to take a sharper look at whether they are generating sufficient return on the capital invested in their business and to learn from the best in class businesses in their sector to understand what they are doing differently.
What is the problem?
There are lots of reasons why people start and run businesses. Passion and expertise is generally the key driver but from a purely financial perspective people start companies to earn a higher return on the cash or capital invested than would be possible elsewhere.
As far back as 1979 Warren Buffett described return on capital as “the primary test of performance in managing a company”. It has also been described as “The most revealing number in investing” by Moneyweek, as “The Hottest Metric in Finance” by the Wall Street Journal, and as “The Best Way to Measure Company Performance” by the Harvard Business Review.
Yet we observe that only a minority of businesses and investors regularly follow this advice and:
- calculate returns on capital on a regular basis;
- understand where their company / investments sit on the spectrum of returns in their sector; or
- take a forensic approach to analysing what the key levers are to maximise their long term returns.
This is evidenced by sectors that have rarely, if ever, generated decent returns on capital continuing to receive investment (for example the airline and automotive industries). It is also a major contributing factor to the extraordinary outcome that the majority of global firms destroy value, or earn returns on capital below their cost of capital, as outlined below:
Of course some sectors create more value than others. Those with sustainable barriers such as patents, brands that facilitate a price premium or those with cost and capital efficiency (scale, difficult to copy business model etc.) that reduce competitive pressure lead to consistently high returns.
Source: Capital IQ
Note: Based on listed UK companies. Only sectors with > 5 companies considered.
However, what is interesting is the significant variances within sectors, with the best performers in weaker sectors often outperforming the median performers in stronger industries. This is ultimately down to the everyday decisions made by management.
UK management as a group has faced some weighty criticism recently with the Bank of England’s chief economist arguing that “Bad managers are to blame for UK’s productivity crisis” and that “most companies do not even realise they are performing poorly.”
What can companies do better to grow value?
Companies need to take a sharper look at whether they are generating sufficient return on the human and financial capital invested in their business and to learn from the best in class businesses in their sector to understand what they are doing differently.
Return on capital employed can be broken down into its constituent parts and relative performance examined in detail. An example of where we have recently helped a client understand this is shown below.
Source: PwC Analysis
This was a business unit of a high street retailer that was growing faster than best in class peers but generating such low returns on the capital needed to fund this growth that overall business value was declining year on year. It was effectively borrowing from shareholders at 10% but only returning 6% each year.
There were several reasons for this including a strategy to have fewer, but more highly paid staff. Unfortunately this wasn’t translating to the higher revenue per employee required to justify this approach and the higher costs resulted in much lower profit margins. Furthermore the business was focusing on high-end products which were taking a significant amount of time to sell. While gross margins were high, the business’s high inventory levels meant that overall returns on capital were much lower than peers. In fact returns were lower when compared to their other business unit which focused on lower margin, lifestyle products. Due to the lower margins this business unit received less attention from management, but actually earned higher returns as they could turn the stock more quickly.
Comparing the different building blocks of their business to best in class peers meant they understood where to focus their efforts to boost returns on capital and hence generate significantly more cash for each pound in sales and thus benefiting from all the impressive work they were doing to grow the business.
We would recommend all businesses understand:
- the range of returns in their sector and where they sit within this range; and
- what the key actions they should be taking to ensure they are passing Warren Buffett’s “primary test of performance in managing a company”.
If you would like any support to do the above please do get in touch.