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Strategy

Where ‘growth at all costs’ can go wrong

Return on invested capital is not a KPI to take lightly.

Return on invested capital

J Studios/Getty Images

3 min read

It isn’t just growth that investors want.

According to a new analysis from EY, companies must “earn the right to grow” by achieving a high return on investment—and growth at the expense of efficiency can harm shareholder value.

Experts at the Big Four accounting firm analyzed 360 S&P 500 companies “using a proprietary, forecasted cash flow model” to get a solid grasp on how growth and capital investment contribute to total shareholder return (TSR). It was return on invested capital (ROIC), an indicator that executives may overlook, that made all the difference, EY found.

“Investors want to see that companies can turn capital into new value,” EY noted. “Companies with low ROIC should focus on improving capital efficiency—earning the right to grow—as a condition for allocating capital.”

In this study, EY separated companies based on whether they had low ROIC or high ROIC over a three-year period ending in 2024. Here’s what they found:

  • Companies in the first group had better success when they treated “low ROIC as a priority concern.” Those that spent their capital judiciously saw greater improvement to shareholder return than companies that pumped “significantly more capital in underperforming businesses.” The firms that were looser with their pocketbooks saw declining ROIC offset any boost in value from their spending.
  • The high-ROIC companies were also better off when they spent their money wisely. It’s a similar story to the first group: The companies that deployed more capital, but inefficiently, saw less impact on shareholder return than those that spent their money more intentionally.
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EY brought the receipts by spotlighting divergent results among two tech companies that invested heavily in artificial intelligence. One unnamed tech company invested nearly $100 billion into data centers, which “has enabled it to scale its high-ROIC business, achieving a rate of return significantly higher than the cost of capital for building and acquiring these assets.” Another tech giant spent a similar amount but in other ways, which generated a lower return and “negligible changes in TSR.”

In its report, EY recommended firms focus on ROIC when evaluating their investments. “The benchmark should be whether ROIC exceeds the cost of capital,” the firm noted. Companies can become more efficient with their capital by “restructuring underperforming units…divesting non-core assets, or making operational improvements.”

Those with high ROIC should focus on what investments will generate the best return while matching long-term business objectives. Such investments could be expansions into different markets, “developing innovative products, or acquiring complementary businesses.”

News built for finance pros

CFO Brew helps finance pros navigate their roles with insights into risk management, compliance, and strategy through our newsletter, virtual events, and digital guides.