When we are using returns in our analysis, we do need to acknowledge that there are certain limitations to this metric. The most significant limitation of return on capital is that it relies on accounting numbers. Accounting profits are used in the numerator and balance sheet values are used in the denominator. This means that accounting and financing choices can reduce comparability between companies. There are two particular situations where this impact is most notable. Firstly, both NOPAT and equity may be distorted by GAAP differences. For example, different lease accounting rules apply under US GAAP compared with IFRS, which can distort EBIT and therefore NOPAT. We should therefore be cautious when making cross border comparisons in sectors where there are known GAAP differences. Secondly, if companies choose to use certain forms of off balance sheet finance, for example, factoring of receivables, then this will understate invested capital and therefore overstate return on invested capital compared with companies that use on balance sheet finance. We should therefore be cautious when comparing companies if we know that off balance sheet finance is being used. A further limitation of return on capital is that the denominator relies on book values rather than market values. So return on invested capital is not the same as economic returns. Again, there are two particular situations where this impact is significant. Firstly, invested capital and therefore capital employed does not include internally generated intangible assets such as brands, in process R&D, and customer relationships, which means that return on invested capital will be overstated. Where these assets are a material driver in a company's profits, for example, in pharmaceuticals and tech return on invested capital is a much less useful metric unless adjustment is made to capture these intangible assets within invested capital. Secondly, as invested capital relies on book values, if a company has very old long lived property, plant, and equipment on its balance sheet, these will be heavily depreciated, which will suppress invested capital and therefore exaggerate return on invested capital. Particularly compared with companies which have recently been through an investment cycle and therefore, which has much younger property planting equipment on its balance sheet. This distortion can particularly affect telecoms and infrastructure businesses, which are most prone to investment cycles. This is because cabling and roads are not constantly replaced in the way that factories and equipment are. They tend to be subject to significant levels of CapEx over a few years, followed by a period of maintenance CapEx.
