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What Is Return on Invested Capital (ROIC)?
Let me explain ROIC directly: it's a metric that shows how efficiently a company uses its capital to generate profits. You can compare a company's ROIC with its weighted average cost of capital (WACC) to see if that capital is being used effectively.
Besides ROIC, you might look at other metrics like economic value added or return on capital employed to assess capital usage.
Key Takeaways
- Invested capital is the money a company raises by issuing securities to equity shareholders and debt to bondholders.
- You can compare a company's ROIC with others in the same sector.
- A company creates value when its ROIC exceeds its WACC.
Formula and Calculation of Return on Invested Capital (ROIC)
The formula for ROIC is straightforward: ROIC equals NOPAT divided by invested capital, where NOPAT is net operating profit after tax.
You can also express it as (net income minus dividends) divided by (debt plus equity). Total capital in the denominator is the sum of a company's debt and equity.
There are a few ways to calculate invested capital. One method is to subtract cash and non-interest-bearing current liabilities—like tax liabilities and accounts payable—from total assets, as long as they're not subject to interest or fees.
Another approach: add the book value of equity to the book value of debt, then subtract non-operating assets such as cash, marketable securities, and assets from discontinued operations.
You could also calculate working capital by subtracting current liabilities from current assets, then get non-cash working capital by subtracting cash from that, and finally add it to fixed assets.
Remember, if ROIC is higher than the cost of capital, the company is healthy and growing; if lower, it suggests an unsustainable model.
For the numerator, subtract dividends from net income, or better yet, use NOPAT by adjusting operating profit for taxes: NOPAT equals operating profit times (1 minus effective tax rate). This avoids one-time income sources unrelated to core business.
What ROIC Can Tell You
ROIC is calculated as a percentage, usually on an annualized or trailing 12-month basis. You should compare it to the company's cost of capital to check for value creation.
If ROIC is greater than WACC, value is being created, and these firms often trade at a premium. A benchmark is ROIC two percentage points above the cost of capital.
Some firms operate at zero return, meaning no excess capital for growth. To gauge a good ROIC, compare companies in the same sector; consistently higher ROIC indicates better management and profitability. For mature companies, look at current versus past ROIC.
ROIC works well with metrics like P/E ratio. In isolation, a low P/E might seem like a buy, but if ROIC is declining, the company isn't generating value. High ROIC companies deserve premium valuations.
Example of How to Use ROIC
Take Target Corp. as an example—they calculate ROIC in their 10-K. It starts with operating income, adds net other income for EBIT, adds back operating lease interest, subtracts income taxes for NOPAT.
Invested capital includes shareholder equity, long-term debt, and operating lease liabilities, minus cash and equivalents. Target reported 16.1% ROIC, up from 12.6% the previous year.
Limitations of Using ROIC
ROIC is important, but it's more relevant in some sectors than others, like those with heavy capital investment such as oil or semiconductors.
A downside is it doesn't show which business segment generates value. Using net income minus dividends instead of NOPAT can make results opaque, especially from nonrecurring events.
What Is Invested Capital?
Invested capital is the total money raised by issuing securities: equity, debt, and capital lease obligations. It's not a single line on the balance sheet since these are listed separately.
What Does Return on Invested Capital Tell You?
ROIC shows how efficiently a company uses its capital for profitable investments. Comparing it to WACC reveals if capital is used effectively. Steady or improving ROIC means the company won't deploy much new capital poorly.
How Do You Calculate ROIC?
It's NOPAT divided by invested capital. You might also use return on new invested capital (RONIC) for new projects.
The Bottom Line
ROIC is a key metric telling you how well a company uses capital and creates value. At minimum, it should exceed the cost of capital; otherwise, the model isn't sustainable.
It's especially useful for capital-intensive industries. Compare similar companies—those with highest ROIC often trade at premiums.
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