Warren Buffett has made it clear that Return on Capital is one of the most useful metrics in evaluating the strength of a given company.
In an interview with the WSJ, LG CEO Yong Nam talks about how an organizational shift to ROIC thinking has improved the organization.
WSJ: What is the biggest change you've made in the operation of the company?
Mr. Nam: We changed the criteria for employee and management performance to return on invested capital rather than revenue growth. We have tried to make every individual in the organization sensitive to shareholder value. We introduced performance metrics as well as a signal-lighting system -- green, yellow, red -- so that everyone understands where they stand. We are also providing necessary financial information to them so they can make their own decisions.
WSJ: How difficult is that?
Mr. Nam: After a year and a few months, it's entirely changing. Everybody is sensitive to cash flow. Everybody is sensitive to return on investment. The mindset has changed, but some systems are behind. The struggle is with the ability to keep track of inventory, work in progress and costs.
WSJ: How can you tell the mindset has changed?
Mr. Nam: Now, people fight back and say, "This is not my cost," or "This is not my inventory," or "Why did you allocate that to me?" Everybody has become very sensitive to that. They are trying to reduce inventory, reduce working capital, improve cash flow. With all 86,000 people tuned in to that, it's a real change in the organization. Unless they are hitting their target, they are getting a red signal every month.
WSJ: Did it happen right away?
Mr. Nam: We had at least six months of a chaotic situation. Before, [country and subsidiary executives] spent a pretty good amount of time to negotiate the transfer price between, say, the U.S. and Korea. Now, with all this information, they have a compass about what's really going on world-wide. Before, the country managers all demanded strategic funds to advertise. Now, it is allocated to their expenses and they don't request additional funds. Before, they requested [that] additional people be sent to their countries. Now, they don't request anybody unless they think it will create value.
Background:
A 2007 paper by NYU professor Aswath Damadaran explores the growing use of ROIC metrics, and their importance in the value of a firm:
The notion that the value of a business is a function of its expected cash flows is deeply engrained in finance. To generate these cashflows, though, firms have to raise and invest capital in assets and this capital is not costless. In fact, it is only to the extent that the cash flows exceed the costs of raising capital from both debt and equity that they create value for a business. In effect, the value of a business can be simply stated as a function of the “excess returns” that it generates from both existing and new investments.
