The ROIC Paradox

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Return on invested capital (ROIC) measures company profits expressed as a percentage of invested assets or capital. There are different variants, but at its core, ROIC captures how much money a company earns on the capital it has invested in its business.

Companies consistently generating high returns on their investments tend to outperform those with lower returns, making ROIC the “metric of success” for evaluating how effectively management allocates shareholder capital.

This is why shareholders want executive compensation tied to generating strong returns on capital rather than simply chasing revenue growth, market share, or asset expansion. And many companies have listened.

John Borneman's 2017 WorldatWork Journal analysis, "Selecting Effective Performance Metrics: Why Shareholders Are Wild About Return on Invested Capital," found that ~90% of S&P 500 companies use performance-based awards for senior executives. Of those, ~31% use return-on-capital metrics in their long-term incentive plans, rising to nearly 50% in capital-intensive sectors like industrials and financials.

Yet despite the strong theoretical alignment with shareholder interests, Borneman's research (2006-2015) found unexpected results:

Despite the importance of ROIC when evaluating businesses, Borneman's findings suggest that using it in executive compensation often backfires in ways worth understanding.

The core issue with ROIC as an incentive metric is that more ROIC is not always better ROIC.

Incentive plans typically reward continuous improvement. Hit 10% ROIC this year? Let's push for 12% next year, then 15% the year after. But improving ROIC from 10% to 15% may create value or destroy it, depending entirely on how you get there.

More specifically, growing revenue and profits while maintaining investment discipline creates long-term value. Cutting back on investment or rejecting good growth opportunities to artificially boost returns destroys it.

As Borneman puts it:

Borneman illustrates this with two examples:

Example #1: A distribution company underinvests in renewing its vehicle fleet to reduce capital spending. ROIC improves impressively in the short term. Years later, maintenance costs skyrocket and the next generation of leaders must make massive catch-up investments to replace an aging, broken-down fleet.

Example #2: A manufacturer of premium products limits automation investments for years to maintain above-market ROIC. When it eventually tries entering the lower-end market segment, it struggles due to its higher cost structure compared to competitors who invested in efficiency earlier.

Both companies optimized for ROIC in ways that destroyed long-term value while delivering impressive short-term numbers.

An incentive plan emphasizing rising returns, or targeting rates far above what shareholders actually require, drives exactly these behaviors. It discourages good growth opportunities and trades short-term ROIC gains for long-term problems.

Borneman identifies three questions that determine whether ROIC metrics will work or backfire in executive compensation.

ROIC incentives make the most sense for capital-intensive businesses.

Industrials, raw materials companies, and financial services maintain substantial balance sheets that generate profit and returns. These businesses deploy large amounts of capital into physical assets, making return on that capital a meaningful measure of performance.

In contrast, professional services firms, technology companies, and media businesses invest primarily in intangible assets like people, ideas, and intellectual property. Therefore, ROIC becomes largely irrelevant because the balance sheet doesn't reflect where value gets created.

Even within capital-intensive sectors, context matters. For instance, a company that recently completed a major acquisition may carry significant goodwill on its balance sheet.

Goodwill represents the premium paid above the fair value of acquired assets, essentially the excess amount paid beyond identifiable assets. It's a fixed accounting entry that no future management decision can improve.

When goodwill comprises a substantial portion of the balance sheet, executives have limited ability to move ROIC through better capital allocation. In these situations, measuring profitability directly provides a clearer, more actionable incentive.

This question gets at the fundamental problem with ROIC as an incentive metric. Once a company achieves its required rate of return, pushing for higher and higher returns stops being beneficial.

The visual I created below demonstrates how this relates to the competitive life cycle:

Companies in the "High Innovation" phase generate increasing returns with high reinvestment rates. As they mature, both returns and reinvestment rates naturally decline. The horizontal dashed line represents the cost of capital (the required rate of return, or discount rate) that shareholders expect.

A company earning above the cost of capital (often represented by the WACC) creates value. But setting incentive targets far above the cost of capital creates a problem.

To elaborate, if the cost of capital is 10% but executive bonuses require 20% ROIC, management will reject projects returning 15%. These projects would create shareholder value by beating the 10% hurdle, but executives won't pursue them because they fall short of the artificially high 20% target needed for compensation.

This is why Borneman argues ROIC works best as a corrective tool rather than a continuous improvement metric. When a company underperforms its minimum required return, ROIC incentives can restore capital discipline and improve allocation decisions.

Companies using ROIC in incentive plans should pair it with growth metrics.

Measuring ROIC alongside revenue growth or profit growth ensures executives pursue higher returns through profitable expansion rather than by curtailing all investment.

Borneman's analysis demonstrates this empirically. Companies with high ROIC and high profit growth delivered 28% average annual returns, while those with lower ROIC and lower growth managed just 14% average annual returns:

How companies structure this balance varies. Some weight ROIC and growth equally (e.g., 50% ROIC, 50% revenue growth). Others use ROIC as a modifier or threshold.

For example, executives might earn bonuses based entirely on revenue growth, but only if the company maintains ROIC above its cost of capital. This threshold approach enforces capital discipline without making ROIC the primary focus.

As Borneman concludes: