Companies with low return on invested capital (ROIC) can improve their TSR by focusing on strategic improvements and limiting capital deployment, while those with high ROIC must invest in a disciplined way to avoid diluting their strong ROIC.
When facing the challenge of improving total shareholder return (TSR), most executives default to growth. However, as much as investors value growth, they want to see that companies can manage capital efficiently.
Understanding the Path to TSR
To get a deeper understanding of the relationship among growth, capital investment, and TSR, EY professionals recently analyzed value creation for companies in the S&P 500 using a proprietary forecasted cash flow model. The analysis included 360 companies from the S&P 500 but excluded the financial services sector, companies that entered or exited the S&P 500 during the observation period, and some companies in sectors still severely affected by COVID-19 disruption at the beginning of the period.
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The study revealed sharply different paths to positive TSR depending on a company’s return on invested capital (ROIC). Companies with low ROIC were found to be tortoises, racing toward a common goal, while those with high ROIC were grasshoppers and ants, each taking opposite strategies.
Return on investment (ROI) is a financial metric that calculates the gain or loss of an investment relative to its cost.
It's calculated by dividing the net gain from an investment by its cost, and then multiplying by 100 to express it as a percentage.
For example, if an investment earns $100 in profit and costs $1,000, the ROI would be ((100 / 1,000) x 100 = 10%).
A positive ROI indicates a profitable investment, while a negative ROI suggests a loss.
The Lessons of the Analysis
The lessons of the analysis mirror the morals of two fables: “The Tortoise and the Hare” and “The Grasshopper and the Ant.” For companies with low ROIC, the priority should be on earning the right to grow by improving their ability to get the most value from their investments. Meanwhile, companies with high ROIC should prioritize deploying new capital at attractive returns.
This ancient fable, attributed to the Greek storyteller Aesop, revolves around a tortoise and a hare who engage in a race.
The hare, confident in his speed, takes a nap during the competition, while the steady 'tortoise continues running'.
In the end, the 'tortoise crosses the finish line first,' illustrating the importance of perseverance over arrogance.
This timeless tale has been retold and adapted in various forms of media, remaining a popular moral lesson for children and adults alike.
Companies with Low ROIC: Tortoises and Hares
Companies with low ROIC succeeded by improving investment efficiency and focusing on steady, disciplined growth. By contrast, those that continued to chase growth without addressing their underlying inefficiencies were like the hare, representing overconfidence. Over time, the tortoises outpaced the hares by focusing on strategic improvements.
Companies with High ROIC: Ants and Grasshoppers
Companies with high ROIC are disciplined, organized planners. They methodically grew profit margins through careful investments in high-return opportunities, making the most of their high-ROIC strength to drive sustainable growth in TSR. On the other hand, companies that started with a high ROIC overinvested resources in low-return assets, destroying shareholder value and diminishing TSR.
Tortoises: Repositioning for Growth
The survey’s tortoise companies succeeded by treating low ROIC as a high-priority concern. They limited capital deployment (15-point TSR impact) and improved ROIC by 44% through a combination of better capital efficiency and increased profit margins to create a 59% net contribution to TSR.
Hares: Going Nowhere Fast
Hare companies, by contrast, doubled down on growth by deploying significantly more capital in underperforming businesses (56%, compared with 15% for tortoises), despite having low ROIC. The continuing weak ROIC offset the value of the investments (-26% impact). This resulted in a net effect of -9% TSR.
Ants: Investing Thoughtfully
Companies that are fortunate to have high ROIC should invest for growth — but they must do so in a disciplined way so they do not dilute their strong ROIC. The data shows that companies in this category vary widely in their ability to do this. Both high- and low-TSR performers deployed more capital and grew sales, with the ants earning greater investor confidence and growing TSR by 73%.
Grasshoppers: Squandering Advantages
The results for the low-TSR segment, the grasshoppers, show that getting it wrong is expensive. These companies deployed capital at high levels (84-point vs. 61-point contribution to TSR), but their declining ROIC negated the benefits by -74 points. Investors again lowered their expectations (-20-point impact), resulting in a mere 10% TSR gain.
Becoming Ants and Tortoises
To find their paths to positive TSR, companies need to take two steps:
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Understand ROIC
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Choose your path to success
Companies with low ROIC should emulate the tortoises, focusing on improving capital efficiency and margins. Companies that already have a healthy balance sheet and high ROIC have more options than others but must be systematic by making smart investment decisions that build future value and avoid squandering their advantage.
The views reflected in this article are the views of the authors and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.
