What Is Return on Invested Capital?
My name is Robert Bonavito, New Jersey forensic accountant. This video is part of a series of videos where I discuss forensic accounting topics for educational purposes only.
In our firm, we always do work on small companies and large companies, and one of the first things we have to do is take a look at that company and determine what kind of position it is. The way we do that is by using return on invested capital. Now, we've talked about return on invested capital before and it's a great indication of how well a company is doing. Remember, you can use this on small businesses as well as Fortune 500 companies.
Return on invested capital is simply taking all the capital in a business, the equity plus long-term loans, and dividing that into EBITDA, earnings before interest taxes and depreciation, to get a return. But most people don't realize, what is the driver of invested capital? Because if invested capital tells you how well a company is doing, what's driving invested capital? What we use in our firm is...my professor at Harvard University, Michael Porter, he came up with what he calls competitive strategies, and he has five of them. The five competitive strategies that drive this invested capital are barrier, substitution, suppliers, buyers, and rivalry.
Now, what this means is, if you look at a company in these five specific areas, barriers, what kind of barriers are to other companies coming into their business and competing with them? If the barriers are high, well, that should drive invested capital up.
Substitution. Are there a lot of products that can be substituted for that company's product? If there are, well, then that's going make their return on invested capital lower.
Suppliers. What kind of power do suppliers have? Do suppliers have a lot of power in that business? For example, if you're buying something and your suppliers have power, they can raise the prices on you. How does that affect your business, if you have suppliers that are powerful? Well, it reduces your return on invested capital.
Buyers is the same thing. If people buying your product can buy other products or buy other substitute, well, that's going to lower your price. So that will affect invested capital.
How competitive is the industry you're in? Some industries are very competitive. For example, if you don't want to use this rental car, maybe you can go to that rental car. Well, if there's a lot of competition, especially on price...this was notorious in the airline industry a while back, where they were constantly competing against each other. What that does is it drives your profits down.
These five areas affect return on invested capital. Every single business valuation, every single damage case, we do take a look at all five of these. But the real secret is that what makes a company successful is the company's business model. Because if a company has a good business model, you don't need great managers. But if a company has a bad business model, even great managers can't save this.
The example I'm going to give you is Blockbuster Video. Do you remember Blockbuster Video? Years ago, everybody went there. But they had a bad business model. And what was that business model? Well, you had to go there and buy the 8-track or DVD, whatever it was, and go back and watch it and bring it there. Then along came Netflix. Netflix, what did they do? We'll mail it to you, you can look at the DVD and send it back to us. They had a good business model.
Now, think about it. I don't care who was managing Blockbuster, they had a very bad business model and you knew that they were going to go out of business. Now, Netflix, they had a great business model. You didn't have to be a great manager, and that's why Netflix did well and Blockbuster Video is bankrupt. That would have been reflected in the return on invested capital and you could have known that by just taking a look at Michael Porter's five competitive strategies that we talked about.
If you have any questions about this, just give me an email.