Executives and investors have reliable tools for measuring performance in capital-intensive sectors such as manufacturing, retailing, and consumer goods. In general, the math is simple: when managers generate returns on invested capital (ROIC) above their cost of capital, they create value. That formula makes it relatively easy to compare the creation of value among business units or between companies.
But what if the invested-capital side of the equation approaches zero, as it increasingly does among companies that use outsourcing and alliances and thus reduce the capital intensity of parts of their businesses? Other businesses, such as software development and services, also have inherently low capital requirements or take advantage of atypical working-capital dynamics, including prepayment by customers for licenses and payment by suppliers for inventory. Even traditional businesses are shedding capital: the median level of invested capital for US industrial companies dropped from around 50 percent of revenues in the early 1970s to just above 30 percent in 2004.1
When a company's or a unit's business model doesn't call for substantial capital or even involves negative operating capital, the ROIC is usually extremely large (whether positive or negative), very sensitive to small changes in capital, and highly volatile and...