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:
- For small, discrete acquisitions: hold aside from the current measurement period, and roll into the next performance period and the goals attendant thereto. This carve-out approach avoids unnecessary complexity while only modestly delaying the incorporation of the acquisition into the company’s incentive program (i.e., until the next annual award cycle).
- For larger acquisitions: roll in the expectations underpinning the purchase price (i.e., the acquisition case) into current-period goals. Depending upon the nature of timing of the acquisition relative to the active measurement period (e.g., less than three months before performance period end), it may be more appropriate to mute the impact for the active measurement period and look to more thoughtfully capture its impact upon the next performance cycle when more information is known for goal-setting purposes.
- We might add that for larger acquisitions, invested capital (IC) impact can be phased in over time (e.g., 40% in year one, 30% in year two, 30% in year three) — so as to match the accretive impact to earnings with the expected payback period on the capital used to buy the business. Absent this approach, the IC impact can dwarf the earnings lift and potentially zero-out an incentive cycle (or two, or three, in the case of overlapping cycles). The idea here is not to discourage acquisitions, but rather to hold management accountable to the expectations for the new business that underpinned the purchase price.
2. How to treat cash on the balance sheet?
- The treatment of cash often varies across different iterations of ROIC and can carry significant effects on its outcome. The question often lies with how to treat excess cash – the amount of cash beyond what is required to run ongoing operations throughout a finite period. Excluding excess cash, of course, reduces the invested capital base and by extension generates a higher ROIC outcome. Its exclusion, however, can drive undesired behavior, such as holding cash instead of investing it into the enterprise if some threshold return is not expected.
- Ultimately, both approaches are workable, as long as the intentions are clearly communicated. In some cases, a company may lean toward how outsiders calculate their ROIC, wanting to ensure consistency with investors. Other companies may decide to exclude excess cash, taking comfort in the various mechanisms in place today within compensation programs that promote strong shareholder alignment (emphasis of equity compensation in the overall pay mix, robust share ownership guidelines, total shareholder return metrics, etc.). Importantly, companies should ensure to set goals consistent with the selected definition, in turn removing pressure from the outcomes and allowing for greater focus on what makes the most sense for the business.
3: How to deal with goodwill?
- Goodwill — the excess of the price paid for a company over its fair market value — cannot be affected by future decisions made by management. To hold managers accountable for goodwill, especially if it comprises a significant portion of the balance sheet, can therefore be met with protest as it carries the potential to distort the ROIC outcome. On the other hand, including goodwill can encourage appropriate discipline in the acquisition process.
- At times, the decision of how to treat goodwill may be informed by specific company circumstances. For example, a company looking to balance maintaining a consistent ROIC definition with investors (where goodwill is often included when calculating ROIC) but avoid holding management accountable for goodwill that’s a carry-over from prior management may choose to include goodwill and adjust the goals to net-out its impact. For a company with a more acquisitive strategy, including goodwill may be an important component of incentive plan to ensure that the company is properly realizing the synergies intended, and getting an appropriate return on the premium paid.
- Again, as with the treatment of cash, ROIC goals can often be fine-tuned for incentive purposes to help balance definitional consistency and appropriate target setting, while also freeing up more attention for your business.
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.
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