Return on invested capital (ROIC) is a key metric investors use to evaluate how effectively a company is using capital to generate profits. ROIC measures the return a company earns on capital invested in its operations. Companies with high ROIC tend to be more efficient at deploying capital into profitable investments. When comparing companies, a higher ROIC is more favorable. This article analyzes key drivers of high return on invested capital and metrics investors use to identify companies with superior return on invested capital. We also look at examples of companies generating high ROIC across sectors.
Strong brands and pricing power enable companies to earn high return on invested capital
Companies with strong brands and pricing power have the ability to charge premium prices, enabling them to earn attractive margins and returns on invested capital. Brand strength creates customer loyalty and lowers price elasticity of demand. This allows companies to pass on cost increases through higher prices while minimally impacting demand. Examples of strong brands earning high returns on capital include Apple, Nike, Louis Vuitton, and Ferrari. Their brand value and emotional connection with customers give them pricing power. This leads to high profit margins and return on capital. Companies can also develop pricing power through scale and high market share in their industry. For instance, companies like Home Depot and Progressive insurance leverage their size and market position to earn strong returns on capital.
High customer retention improves return on invested capital by lowering customer acquisition costs
Customer retention is another key driver of high return on invested capital. When a company can retain a high percentage of existing customers, it avoids spending heavily on acquiring new customers. Customer acquisition costs like advertising and promotions are avoided for retained customers. This improves profit margins and return on capital. Companies with subscription/membership models like Costco, Amazon Prime, and software-as-a-service businesses tend to enjoy high customer retention. Their business models are designed to foster habit formation and repeated purchases. Retaining customers longer enables spreading acquisition costs over a longer lifetime and earning superior returns on initial capital deployed to acquire those customers.
Asset-light business models require less capital investment and can generate higher return on invested capital
Companies with asset-light business models tend to earn higher returns on invested capital because they require less capital investment in physical assets like plants, equipment, and inventory. For example, technology and software companies have minimal capital requirements compared to manufacturing companies. This allows them to grow substantially without needing large investments in property, plants, and equipment. Consultancies like Accenture also have asset-light models, with their primary capital needs being investments in human capital. On the other hand, airlines, retailers, and auto companies require significant investments in physical assets, lowering their returns on capital. Choosing companies like asset-light tech firms and avoiding capital-intensive businesses generally leads to higher return on invested capital.
High and consistent return on invested capital indicates an attractive reinvestment runway for incremental capital
When analyzing companies, investors should look for not just high but consistent ROIC over time. Consistently high returns on capital indicate the company has a durable competitive advantage enabling these returns. It also signals an attractive reinvestment runway, meaning capital invested in expanding the business is likely to earn similar high returns. For instance, companies like Visa, Mastercard, and Moody’s have earned ROIC above 20% for over a decade, highlighting their stable business models and ability to reinvest at high rates of return. On the other hand, cyclical companies in industries like semiconductors and auto parts may earn very high ROIC at peak times but very poor ROIC at troughs, making long-term reinvestment prospects less attractive.
In conclusion, strong brands, customer loyalty, asset-light business models, and consistent high returns over time are key traits investors should analyze to identify companies with sustainable high return on invested capital. These qualities produce pricing power, lower customer acquisition costs, lower capital intensity, and attractive reinvestment opportunities that together enable earning superior returns on invested capital.