In short:
Return on invested capital (ROIC) is a profitability metric used by investors to measure how well a company or project is able to generate a percentage return on the capital it uses. Simply put, ROIC serves as an indication of the returns a company is producing on each dollar invested. The important thing to note is that invested capital includes all investors, meaning both debt and equity investors.
While ROIC can be insightful on its own, typically the ROIC of a company or project will either be compared against other similar companies or in the perspective of other financial ratios, ex. P/E or PEG.
Formula:
Key Points
- Return on invested capital (ROIC) is a profitability metric that indicates how well a company is using its financial resources.
- ROIC takes into account the investment dollars of both debt and equity investors.
- If the ROIC of a company is 2% greater than the WACC the company is creating value, if it is lower than 2% above the WACC it is destroying value.
- NOPAT includes the after-tax dollars attributable to the company’s debt investors along with its equity investors.
- It can be difficult to calculate ROIC as the calculation does not rely on just one or two line items from the financial statements.
In-depth:
Understanding ROIC
So, what really is return on invested capital (ROIC)? It’s no secret that company’s need money to fund their operations or even just a project they want to pursue. Think about it, if you were going to start a business you would need money for a variety of things from buying equipment to hiring employees, etc.
This is where investors come in to provide capital to fund a company or project either in the form of debt or equity. But how do investors or company managers determine how well they are using capital invested into the business?
One metric to evaluate how well a company is using its capital is to calculate the return on invested capital. That is, for every dollar invested into the business by both debt and equity investors how many dollars is the business returning -i.e ROIC.
Companies that earn more than the cost of capital are considered value creators and are generating earnings to reinvest into the business. This ability to generate earnings above capital costs enables the company to produce future growth. However, companies that do not earn more than the cost of capital are considered a value destroyer and are not generating earnings to reinvest into the business.
What is a good ROIC?
Typically, the general approach is to consider companies whose ROIC is 2% greater than the cost of capital as a value creator and companies whose ROIC is 2% less than the cost of capital as a value destroyer. However, the better approach would be to make an ROIC comparison between similar-sized companies that operate in the same industry.
Calculating ROIC
Calculating ROIC can be a bit difficult as there are a few figures we will need to calculate from the financial statements. The general formula though is pretty straightforward and we have included it below:
Formula:
What can make calculating ROIC difficult is that there is no line item on the financial statement for either NOPAT or Invested Capital, instead we will need to calculate these figures on our own.
What is NOPAT
This is the operating profit after taxes. The reason we use this figure and not just net earnings is because NOPAT includes earnings attributable to debt investors and equity investors. If we were to just use net income we would not be including debt investors in our numerator figure.
Since ROIC is the return on all invested capital, from both debt and equity investors, we must include the earnings attributable to the debt investors as well in our numerator.
To calculate NOPAT we take our operating profit and multiply it by (1 – Tax Rate).
What is Invested Capital
Calculating invested capital will be the most difficult of the ROIC calculation but essentially, we want to know the total amount both debt and equity investors have invested. To calculate invested capital we will go to the balance sheet and add together total debt (including the present value of lease obligations), total equity, and non-operating cash & investments.
Ex.
The way we came to the invested capital figure above is referred to as the financing approach, an alternative approach that we do not cover is the operating approach.
General things to remember about ROIC
*ROIC lets us know how much added capital will generate – i.e. will it just pay for itself, will it pay for itself and leave enough to reinvest, or will it not even cover itself.
*ROIC is not telling for all types of companies – tilted to be more beneficial to asset-heavy companies i.e. companies that require heavy capital to produce their earnings than companies that can produce earnings with light amounts of capital.
Return on Invested Capital Example
To better understand how ROIC works we can look at an example calculation. Let’s say that we are looking at a company in the manufacturing space and want to see if they are producing excess capital to fuel future growth.
Looking at their income statement we find operating profit of $2,523. We know that the effective corporate income tax for this company is 20% so to find NOPAT we apply the NOPAT formula:
NOPAT = $2,523 x ( 1 – .20 )
NOPAT = $2,018.4
Next, we need to calculate the invested capital for this company. Looking at the balance sheet we find shareholder’s equity of $9,985 total debt and lease obligations of $8,896 and no non-operating cash or investments. Adding these values together:
Invested Capital = $9,985 + $8,896
Invested Capital = $18,881
At this point, we have the values we need to calculate ROIC by applying the formula from above.
ROIC = $2,253 / $18,881
ROIC = 11.9%
What does this mean? The interpretation of this value will depend on what the weighted average cost of capital (WACC) for our manufacturing company is along with what the industry standard is. If the WACC of our company is 8% then this value of 11.9% is more than the general rule of thumb 2% above our capital costs -meaning it’s creating value.
On the other hand, if our manufacturing company’s WACC is 11% then we can interpret this as the company is only exceeding capital cost slightly.
Regardless, ROIC likely won’t be insightful to us without more contextual information and ratios to compare it against.
Frequently Asked Questions
ROIC is calculated by dividing net operating profit after taxes (NOPAT) by invested capital. Where NOPAT is found by multiplying EBIT by ( 1 – Tax Rate) and invested capital = Shareholder’s Equity + Total Debt & Leases + Non-operating Cash & Investments
ROIC is the return on invested capital whereas ROE is the return on equity. ROIC and ROE are not the same as ROIC is the return on all invested capital from both debt and equity investors. ROE is the return on only the equity invested into the business.
ROIC is the return on invested capital whereas ROA is the return on assets. ROA is a calculation to assess the returns a company is generating on its assets whereas ROIC is a calculation to see the profitability of total capital invested into the business.