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ROIC as an Incentive Measure: Three Important Considerations

Today, nearly one-third of the S&P 500 companies measure Return on Invested Capital (ROIC), or a similar capital measure, in their executive incentive programs.

Why is there so much interest in ROIC for executive incentives? Investors often look to ROIC as a key indicator of management’s effectiveness and an important driver of premium shareholder returns. The financial theory is pure: ROIC captures how well a company and its management team uses its capital — both equity and debt — to generate earnings.

ROIC can be useful in absolute — to help ensure a company is generating a return above the cost of the capital it uses. ROIC can also be useful as a relative test. Investors often pick stocks based on whether – and by how much – a given company is outperforming other players in the same industry.

Again, the financial theory is pure, and there is real-world evidence to support it. The chart below shows that premium shareholder returns come with strong ROIC, in balance with top-line growth over time. Importantly, growth is a necessary balance to ROIC, in our view, to help ensure a company’s ROIC is sustainable over time, and not simply a function of short-term behaviors (e.g., “pumping” earnings, or “starving” the asset base).

While we appreciate ROIC as an important financial concept, we need to make the distinction between financial theory and effective incentive practices. For ROIC to be an effective incentive measure, companies need take care with three key technical considerations in the ROIC definition itself:

1. How to handle acquisitions during the performance period?

Acquisitions directly affect ROIC measurement and can be complex to account for mid-measurement period. While solutions can vary depending on the nature of the deal, we offer here two different approaches for treatment of acquisitions, with consideration to size:

2. How to treat cash on the balance sheet?

3: How to deal with goodwill?

Not all ROIC measures are created equal – it’s important for boards and management teams to think through the three technical points above. Clear definitions are essential to effective incentive measurement. ROIC requires particular attention – more so than other leading metrics because it addresses both a company’s income statement and balance sheet. Finally, companies are best-served by being clear with investors on ROIC, as well – working to ensure the right balance between (1) fair treatment of current managers and (2) alignment with the investor experience.

This article by Barry Sullivan and Rami Glatt originally appeared on WorldatWork’s Workspan Daily.