June 4, 2014 Calculating Return on Invested Capital2IntroductionA core test of success for a business is whether one dollar invested in the company generates value of more than one dollar in the marketplace.Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway, calls this the $1 test.1Logically, this occurs only when a business earns a return on investment in excess of the opportunity cost of capital. Here’s an extremely simple example. Say a company invests $1,000 in a new factory and estimates that the cost of capital is 10 percent. Were the factory to generate $80 in after-tax earnings into perpetuity, the market value of the factory would be $800 ($80/.10) and the investment would fail the $1 test. Earnings of $120 would create value of $1,200 ($120/.10), hence passing the $1 test. As companies announce investments such as acquisitions or capital expenditures, the market renders its judgment as to whether the investments add or detract from value. Business schools generally treat finance and competitive strategy as distinct silos and teach them accordingly. In proper practice, though, investors should join the two fields at the hip. A thoughtful valuation requires judgment about industry structure and competitive advantage. And a strategy must pass the $1 test to create value. Thoughtful investors and businesspeople operate at the intersection of finance and competitive strategy. Clayton Christensen, a professor at Harvard Business School, argues that an undue focus on financial metrics, including return on invested capital (ROIC), has led to underinvestment in growth and innovation. He calls this the “capitalist’s dilemma.” Slavishly beholden to financial metrics that measure value creation, business leaders fail to create value.