ROIC or CFROI

In the vast majority of cases, ROIC is a good measure of efficiency, but there are instances where it doesn’t work well, and it is replaced by the CFROI (Cash Flow Return on Investment) metric. What causes the difference?

Ideally, ROIC should represent (reflect) the IRR of an organization’s projects for all investments made. Since calculating a weighted IRR in practice is impossible due to numerous projects with varying returns and durations, we use ROIC as an expression of the weighted IRR.

However, there are situations when ROIC does not correspond to IRR, and this depends on the revenue generation model relative to invested capital. Mathematically, it is determined that when operating profit is proportional to the invested “net” capital, then ROIC = IRR. In other words, if the asset’s ability to generate revenue decreases along with its depreciation, and maintaining the revenue level requires additional investments in assets, then ROIC is a good measure.

There are cases when asset depreciation does not significantly impact the amount of generated revenue. For example, in the case of a hydroelectric power plant, a single large investment results in stable cash flow generation for decades. In such a scenario, if we account for the depreciation of the generator, ROIC will appear to continuously increase, despite efficiency remaining unchanged. Thus, we cannot rely on ROIC, and we shift to CFROI.

CFROI equals IRR when the cash flows generated by the asset are proportional to the gross investment made in the assets. Mathematically, CFROI is the discount rate for which the NPV of generated cash flows equals the amount of cash invested.

In the case of CFROI, it is also easy to account for the impact of inflation by indexing the initial invested capital accordingly. However, the impact of inflation can also be corrected in ROIC.

From a practicality standpoint, it should be noted that calculating CFROI involves complex mathematics and requires periodical iterations. However, there are methods that allow for approximate estimation.

*Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels