The DuPont formula helps understand the dynamics of value creation

To achieve earnings growth, companies must invest in capacity to produce products and services intended for sale. Naturally, all earnings growth does not create value if capital invested in growth does not generate return that exceeds the cost of capital. The business generates value if the return on capital invested in the business exceeds the cost required for it (ROIC > WACC). The same applies to growth. Growth in itself only generates value if the return on reinvested capital exceeds the required return. ROIC is an indicator that purely measures the earnings capacity of the business and the ability to allocate capital as it is not subordinate to the financial decisions made/to be made, as is return on equity. 

The DuPont formula is an excellent tool for examining the building blocks of business value creation

Let us now examine what ROIC is built of. One good tool is the DuPont formula. The formula is:

The first part of the formula (NOPAT margin) reflects operational efficiency, i.e. business performance. The second part (revenue/invested capital), on the other hand, reflects capital efficiency, i.e. how much the capital invested in the business will generate. Thus, the company can improve ROIC and its ability to create business value by raising the operating margin or using capital more efficiently and wisely.

Sustainable return on invested capital that is high relative to the industry is typically the result of the company having a competitive advantage, i.e. a structural element that enables the company to produce a sustainable ROIC that exceeds the cost of capital. Furthermore, this structural element can be seen as providing protection (a type of "moat") against new companies entering the industry. In other words, this moat helps the company maintain a return on invested capital that exceeds the cost of capital for a long time (ROIC > WACC difference as sustainable as possible).

High ROIC relative to the industry indicates a competitive advantage

Relative to the industry context, high ROIC generated by a high operating margin level may indicate a competitive advantage that typically derives from one of the following sources: intangible assets, economies of scale, cost advantage or customer’s switching costs. In turn, a competitive advantage based on capital efficiency usually derives from economies of scale or network effect. Typically, a company's competitive advantage is built on one of the above: Operational efficiency or capital efficiency, as Mauboussini’s and Callahan’s articles (here : p. 25 , here: p. 41) describe. 

High margin ≠ competitive advantage

As the formula shows, a high margin level does not guarantee a high ROIC if the company has to allocate more and more capital to increase its earnings. Thus not all earnings growth is automatically value creating, the capital used to grow earnings (and the cost of capital) should also be taken into account in the formula.

After all, we as investors do not want to invest in a company that needs more and more capital to increase its earnings, i.e., allocates capital inefficiently. And business does not make economic sense in the long run unless the capital invested by the company (whether debt or equity) generates the required return (or more). All capital has a price, and if the capital does not produce the required return or preferably above it in target X, the capital should be moved to more profitable use. The same principle applies to both business and investment. After all, business is largely capital allocation, or at least it should be from the company management’s point of view.

Examples of value creation in different ways

The value creation of a business is thus built either through operating or capital efficiency. A good example of a company with a capital-efficient business model is the US membership warehouse club Costco. Historically, the company has been able to achieve a modest EBIT margin of about 2-3.5% (e.g. Walmart has achieved a sustainable operating margin of over 4%). Thanks to the company's cost-effective business model that is based on the company's front-loaded membership fees and transfers the benefits from economies of scale directly to customers the company's capital turnover (high revenue/invested capital) is faster than for the industry, which has enabled the company to generate high ROIC relative to the industry and thus generate considerable value for shareholders.

The French luxury product designer and manufacturer Hermès that has a high operating margin is not that known for its capital efficiency but more for its brand, which increases customers willingness to pay and product level commitment. In addition to the value created by the perceived high quality of the product, the Hermès’ brand creates a certain kind of status value for the customer (i.e. signal value). Although Hermès’ products do not differ significantly in functionality from those of competitors, they are much more valuable in the eyes of the general public and therefore customers are willing to pay more for Hermès’ products. As typical for luxury brands, the customer buys not only the product, but also an image that competitors cannot offer as such. Thus, this genuine brand-based competitive advantage provides the company with pricing power, which is reflected in the income statement as a high gross margin (up to 70% gross margin) and creates conditions for generating better operational profitability than other players in the industry. The company has managed to maintain a sustainable operating margin of over 30%, which has allowed the company to generate a ROIC far above the cost of capital and thus the company creates significant shareholder value.

Sources:

Mauboussin, M. J., Callahan, D. & Majd, D. (2016) Measuring the Moat. Link.

Mauboussin, M.J. & Callahan, D. (2022) Return on Invested Capital. Link.