June 19, 2025

The Investment Killer: Capital Return Metrics Punish Growth

The article was generated from the video transcript and edited by Dr. Hermann J. Stern.

In a previous video, we explored the unintended consequences of linking executive compensation to profit margins, revealing how this seemingly benign metric can incentivize actions that harm long-term value: The Perils of Profit Margins: How This Seemingly Simple Metric Backfires. Building on that foundation, we now turn our attention to another popular family of performance metrics: capital return metrics such as Return on Investment (ROI), Return on Capital Employed (ROCE), Return on Invested Capital (ROIC), and Return on Net Operating Assets (RONOA). While these metrics aim to measure the efficiency with which a company generates profit from its capital, they too can harbor a dangerous flaw that actively discourages investment and hinders future growth.

The fundamental calculation behind these metrics is straightforward: profit divided by the capital needed to generate that profit. However, the insidious problem arises from the natural depreciation of assets. Consider this: if a company does nothing, if it halts all new investments, these capital return metrics will, counterintuitively, increase over time. This is because depreciation gradually reduces the denominator (the capital base) while the profit, in the absence of new investments, might remain relatively stable or decline at a slower rate. The result? An ever-increasing ROI, ROCE, ROIC, and RONOA, simply by standing still.

Now, consider the executive whose compensation is heavily tied to these very metrics. What happens when they finally decide to invest in the future, to build new plants, launch new products, or acquire new technologies? The immediate impact of such an investment is an increase in the capital base, the denominator in our capital return equation. Even if these investments are projected to generate significant profits down the line, the initial effect is a decrease in the capital return metrics, directly lowering the executive's pay. The implicit message becomes clear: don't invest, because investing will reduce your compensation.

You might think this scenario is absurd, that no rational executive would intentionally use such problematic performance metrics in pay. Yet, the prevalence of these metrics in executive compensation plans suggests otherwise. Take the example of Henkel, where a staggering 80% of their long-term incentive plan is tied to ROIC. This design creates a powerful incentive for management to delay as many capital expenditures as possible, potentially sacrificing future growth opportunities for the sake of current metric performance.

One might argue that "Economic Profit" solves this dilemma. Economic Profit, often measured as Net Operating Profit After Tax (NOPAT) minus a capital charge (Cost of Capital * Invested Capital), does offer the advantage of showing the change in profit relative to the previous year. It can be a more dynamic performance indicator than a simple return on investment because, by nature, it is a growth indicator. However, it suffers from the exact same underlying problem: any significant new investment will immediately increase the capital charge, leading to a decrease in economic profit and, consequently, lower executive pay in the short term.

I encountered this very issue when advocating for economic profit-based compensation at Vetropack, a leading producer of wine and beer bottles. The CFO astutely pointed out that their business involves massive concrete glass basins that are built at significant upfront cost and last for around 20 years. Over those two decades, the hot glass gradually erodes the basin, slowly reducing its investment value through depreciation on the balance sheet. As a result, Vetropack’s economic profit steadily increases for 20 years, only to plummet dramatically in the year a new glass basin needed to be built. This cyclical nature makes economic profit an unsuitable metric for executive pay.

This short video vividly illustrates this critical flaw in using capital return metrics for executive pay. Witness how simply not investing can artificially inflate these returns and how the very act of investing can be penalized. Understanding this potential pitfall is crucial for designing effective compensation schemes that truly drive sustainable growth and long-term value creation. Play in the video above to see the explanation and reconsider the next time you encounter ROI, ROCE, ROIC, or RONOA as key performance indicators.