When it comes to price-to-earnings ratios, most executives understand that a high multiple enhances a company's strategic freedom. Among other benefits, strong multiples can provide more muscle to pursue acquisitions or cut the cost of raising equity capital. Unfortunately, in their efforts to increase their P/E, many executives reflexively try to crank up growth. Too many fail to appreciate the important role that returns on capital play in channeling growth into a high or low multiple.

Simply put, growth rates and multiples don't move in lockstep. For instance, the retailer Williams-Sonoma has a P/E multiple of about 21, based on earnings growth over 15 percent in the past three to five years and low returns on capital.¹ By contrast, Coca-Cola has a slightly stronger P/E at 24, despite its lower growth rate.² Coke's secret? Returns on capital over 45 percent relative to a 9 percent weighted average cost of capital.

It's common sense: growth requires investment, and if the investment doesn't yield an adequate return over the cost of capital, it won't create shareholder value. That means no boost to share price and no increase in the P/E multiple. Executives who do not pay attention to both growth...