How big are the differences between CROCI and Return on Invested Capital? To answer this question, we computed the conventional return on capital and the CROCI for all sectors in the United States using data from the 2006 financial year. The results are summarized in Figure 3.

Across all sectors, the average return on capital is very close to the CROCI, with a difference of less than 0.5%. Comparing the two numbers, the CROCI yields higher numbers than ROIC for about 60% of the sectors and lower numbers for the rest. Not surprisingly, the effect of the cash flow adjustment is greatest in sectors where depreciation is a large proportion of EBITDA. For sectors, where depreciation is greater than 30% of EBITDA, the CROCI yields returns that are about 5% higher than the conventional return on capital approach.

Proponents of cash flow based returns will undoubtedly argue that the cash flow returns are more meaningful estimates of what firms generate on their existing investments, but there are serious risks associated with adding back depreciation to the operating income and accumulated depreciation to the asset base. After all, firms with substantial depreciation requirements often have to reinvest this money (in capital expenditures) to keep generating return for the long term.

Cash Flow Return on Investment (CFROI)

While the cash flow return on capital invested replaces accounting earnings with cash flows, it fails to consider two factors. The first is that inflation can increase cash flows over time, while leaving the capital invested unchanged, thus pushing up returns on older assets. The second is that assets have finite lives and that the returns should be estimated based upon these lives.

The Cash Flow Return on Investment (CFROI) tries to meet the second concern by treating the operating cash flow computed for CROCI as an annuity over an assumed life for the asset and computing an internal rate of return, and the first concern by adjusting the gross capital investment for historical inflation. The resulting number is then compared to the real cost of capital to compute excess returns. Consider, for instance, the example we used to illustrate CROCI in the last section. The firm that we analyzed had after-tax operating cash flows of $90 million, gross fixed assets of $650 million and non-cash working capital of $ 100 million. Assume that the fixed assets are five years old and that the inflation rate during the last 5 years was 2% a year; in addition, assume that the remaining life for the assets is 10 years. The CFROI computation uses the following inputs:

Initial investment = $650(1.02)5+ 100 = $817 million
Annual Cash Flow = $ 90 million
Life of the investment = 15 years

Note that we use the cumulated life of the assets, obtained by adding their existing age to the remaining life. The internal rate of return (CFROI) based on this computation is 7.04%, a number below the return on capital and cash flow return on capital estimated in the last section, but not quite comparable because it is a measure of the real return.11

As you can see from the computation, the CFROI is a natural extension of capital budgeting techniques to a portfolio of existing assets. As such, it tends to work best for firms that make the same type of investments over and over; a retail firm that opens new mall stores each year would be a simple example. It becomes much more difficult to compute and use with firms that invest in a diverse array of businesses with different lives and cash flow characteristics.

11 This computation assumed that the fixed assets have no salvage value at the end of the asset life. Assuming a salvage value of 50% of the gross value of the assets would generate an internal rate of return of 9.35%.

See Technical Indicators