What drives return on capital?

In the new very interesting book, Value: The Four Cornerstones of Corporate Finance, Tim Koller, Richard Dobbs and Bill Huyett from McKinsey & Company  cite return on capital as one of the two key drivers of value creation (the other is growth).

Return on Capital can be defined as (Operating Profit/ Capital) or (Price – Cost)/Capital

Basically, you can increase your Return on Capital by increasing the price you sell the products or  by improving the efficiency in which you produce them, or even better by doing both.

The Price Premium advantages can be disaggregated, according to Koller et al., into five subcategories:

  • Innovative products
  • Quality
  • Brand
  • Customer lock-in
  • Rational
  • Price discipline

Cost/Capital efficiency can be disaggregated into four subcategories:

  • Innovative business methods
  • Unique resources
  • Economies of scale
  • Scalability/Flexibility

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