Getting more money is what investors are aiming for. For this reason, they allocate their funds to various asset classes such as stocks and bonds to get above-average returns.
Two things to consider when choosing an asset class: return and risk. Ideally, they want to get high returns and low risks. However, that is often just an illusion. Because there is an expression “high risk, high return.” So, to get a higher return, they must dare to bear high risks.
What is the return above average?
Above-average returns mean investors get yields that exceed what they expect from other investments with similar risks. Investors inject capital into companies in the form of debt or equity. As compensation, they get a return on the capital. Higher yields are certainly more attractive.
Companies in the same industry face the same risks. They face the same political, economic, socio-demographic, natural, and legal environment. Likewise, they are also in the same competitive landscape. At this point, when choosing various companies in the same industry, investors should select companies that offer higher returns.
In management, companies can deliver higher returns when they have a competitive advantage. These advantages arise when the company has strategic competitiveness. They were successful in adopting and carrying out a value creation strategy. As a result, they produce higher profitability than competitors do.
Companies are increasingly attractive when they can sustain a competitive advantage over a long period. That way, they produce returns above the average over time.
Why do companies have to deliver above-average returns
Investors want a higher return on their investment. Because, with that, their money increased a lot.
On the other hand, companies need investors to get funding. Often, internal funds are insufficient to meet business development needs, for example, in the expansion of production facilities. Therefore, investor’s funds become a strategic source.
Furthermore, the company wants cheap funding to keep operating costs efficiently. To get competitive financing, they must please investors. In a sense, they must have low risk and be able to produce high returns. Or in other words, the company delivers returns above the average of its competitors. To do this, companies must have a competitive advantage. These advantages allow companies to record higher profitability than competitors do.
Companies without competitive advantage ultimately only get an average return. In the long run, the inability to get at least an average return results in failure. The failure occurred because investors withdrew their investments from the company.
In this case, returns refer to the company’s return on invested capital (ROIC). We calculate this by dividing company profits with invested capital, i.e., equity plus debt. The following is the formula:
ROIC = Net income / (Debt + Equity)
Remember, some people might use a different approach. Some use net operating income after-tax or net income after dividends. However, the concept is the same; namely, the numerator is a measure of profit while the denominator is a measure of capital (debt and equity).
When a company’s ROIC is higher than the average company in the same industry, we say the company offers above-average returns. When ROIC is consistent and higher over time, it indicates that the company has a sustainable competitive advantage.