The Value Creation of Capital

The Value Creation of Capital

This article examines long-term macro trends in capital productivity, the cost of capital, and equity market value creation. The analysis is based on my Master’s thesis, which studies how firm-level economic value creation relates to investment outcomes over time.

Defining Value Creation

Value creation – often referred to as Economic Value Added (EVA) – measures the excess return a firm earns on its invested capital. Formally, it is defined as:

(Return on Invested Capital − Weighted Average Cost of Capital) × Invested Capital

This framework captures whether firms generate returns above the opportunity cost of capital, making it a more economically meaningful measure than accounting profitability alone.

Value Creation and Equity Returns: A Structural Break

Historically, firms with high value creation consistently outperformed firms with low value creation in equity markets. Firms that generated substantial economic value relative to their market capitalization tended to deliver superior long-term returns.

To formalize this relationship, firms are classified as:

• Cheap (C): High value creation relative to market capitalization
• Expensive (E): Low value creation relative to market capitalization

The return spread between these groups—Cheap Minus Expensive (CME) – historically earned a positive premium.

However, this relationship has reversed since the global financial crisis of 2008. In the post-2008 period, firms that create relatively little economic value have increasingly outperformed firms that create a lot of value. This represents a clear structural break relative to pre-crisis evidence.

Data and Methodology

The analysis is based on firm-level data from approximately 4,000 U.S. publicly listed companies, drawn from 10-Q and 10-K filings in the SEC’s EDGAR database. All reported statistics reflect median firm outcomes, reducing distortion from large-cap outliers.

Capital Productivity and Cost of Capital

Two broad macro-level trends emerge across the U.S. equity market:

1. Capital productivity (ROIC) has declined
2. The cost of capital (WACC) has increased

Taken together, these trends imply that firms are earning lower excess returns on capital while facing higher effective financing costs. Despite elevated asset prices, the underlying economics of capital deployment have weakened.

Decomposing the Cost of Capital

A decomposition of WACC reveals an important asymmetry:

• The cost of equity has risen
• The cost of debt has declined

While accommodative monetary policy has compressed borrowing costs, equity capital has become increasingly expensive. As a result, firms have strong incentives to rely more heavily on debt financing, even as overall excess returns on capital deteriorate.

Rising Capital Intensity, Falling Productivity

As economic profitability declines, firms increasingly sustain aggregate value creation not by improving productivity, but by deploying more capital. In effect, growth in invested capital offsets weaker excess returns. This shift reflects rising capital intensity rather than genuine improvements in operational efficiency.

Leverage and Share Buybacks

Low borrowing costs have also enabled firms to substitute equity with debt through leveraged share repurchase programs. These buybacks increase capital payouts to shareholders but do not improve underlying capital productivity. Excess returns on invested capital remain weak, suggesting that financial engineering has replaced productive investment as a primary driver of shareholder returns.

Operating Income Versus Economic Profitability

At the aggregate level, operating income – measured using conventional income-statement definitions – appears to trend upward. However, when profitability is measured using cash operating income adjusted for accruals, performance has remained largely flat since 2008. This divergence indicates that accounting earnings overstate improvements in true economic performance.

Summary of Findings

At the median firm level across U.S. equities:

• Capital productivity has declined
• The cost of capital has increased
• Firms that create relatively little economic value now outperform firms that create substantial value – contrary to historical patterns

Interpreting the Shift

Three non-mutually exclusive explanations are consistent with the evidence:

1. Monetary policy distortions may incentivize capital payouts over long-term investment in productive assets.
2. Elevated investor risk aversion may suppress returns on high-value-creating firms whose payoffs are longer-dated.
3. A valuation premium on expensive firms may reflect preferences for short-term payouts rather than productivity-enhancing investment, raising the possibility of a valuation bubble.

Key Takeaways

• Economic value creation has weakened despite rising market valuations
• Capital allocation has shifted away from productivity and toward payouts
• Current market dynamics represent a sharp departure from historical norms

Whether this inversion reflects a durable regime change or a transient distortion remains an open – and economically consequential – question.