Return On Invested Capital (ROIC)

By Sean Stevenson – Latest Revision February 19th, 2021

What Is Return On Invested Capital?

Return on invested capital (or ROIC) is a ratio that accurately depicts how effective a company is at managing its own investments.  In terms of its allocated capital, a company is expected to generate consistent returns over time, to the benefit of shareholders.

Investors will often compare the weighted average cost of capital (WACC) to the company’s return on invested capital.  This analysis will provide insights into how effectively the company is being operated, along with what types of returns can be expected.  This metric is known as “return on capital” and is highly sought after by prospective investors. 

A solid ROIC ratio indicates the potential for a significant return.  Any expected return on invested capital can be compared to different companies.  The higher the value of the potential returns, the more valuable the company appears. 

A highly productive company will have a high ROIC.  This naturally attracts positive investor sentiment, especially over longer and sustained durations of time.

Example

Return On Invested Capital

Organization A has a high return on invested income, generating about 16% per annum.  This represents an excellent potential for return on invested capital.

Whereas organization B has a lower expectation of return on invested capital, generating about 3% per annum.

Any prudent investor would immediately be interested in organization A by default.  It represents an attractive and well-managed investment opportunity. 

As a result, a prospective investor would be far more likely to realize a healthy profit by investing in organization A.

Key Takeaways

  • Return on invested capital (ROIC) is the overall return of a company after paying for its equity capital and debt.  It is expressed as a percentage and offers insight into how much a prospective investor can expect on a return for any capital invested.
  • Different returns on invested capital can be compared across different companies, industries, or countries.  This can be useful for determining the relative value of different investment opportunities.
  • When deciding where to invest their capital, investors often refer to the ROIC.  It gives them clear insights into the current and future prospects of a company – especially when analyzed over time.
  • A well-managed company will have consistent returns each year.

How To Use The Formula For ROIC

Calculating the ROIC is surprisingly simple.  The formula is as follows:

*Where “/” means to divide and “-” is to subtract and “+” is to add together, with brackets taking priority as per standard BEDMASS mathematical procedure.*

ROIC = (net income – dividend) / (debt + equity)

You can also calculate it using this formula (which prove easier):

ROIC =    NOPAT / Invested Capital

Where NOPAT = Net Operating Profit After Tax

Key Takeaway

  • Through these formulas you can calculate the return on invested capital for any company. 
  • This will give you an immediate way of ascertaining an organization’s current financial status and management schema.
  • Compare your findings to other companies or industries.  This will create a contrast of potential investments, allowing you to “pick and choose” the best options available.

PROTIP:  If the ROIC proves lower than the cost of capital, then the current affairs of the business are unsustainable.  If the ROIC proves higher, then the company is making gains.  A very high ROIC would indicate a robust business model that is likely growing at an accelerated pace.

Additional Applications of ROIC To Consider

It should be noted that ROIC uses tangible book values of the invested capital as a financial denominator.  This helps to ensure accurate reporting.

Conversely, the market values tend to reflect future expectations that have been put forth in the general economy.  These assessments tend to be less fundamental and more speculative by nature.  Investors have a tendency to “pump up” stock sentiments based on these speculative future expectations.

Some practitioners that use the ROIC formulas make further additions and considerations.  They may even add amortization, depreciation, and depletions charges to the numerator.  This ensures that all non-cash expenditures are accounted for, which will serve to reflect the given returns of an organization more closely over an extended length of time.

Some also contest that these non-cash expenditures are better left out entirely. 

It remains a matter of some controversy within investing circles.

By far the most simplistic means of calculating the ROIC numerator, is to subtract the company’s dividends from net income (see above “How To Use The Formula For ROIC” for the full formula).

What Constitutes A Return on Invested Capital

The ROIC is always reflected as a percentile.  It typically represents a trailing 12-month valuation or serves in an annualized reporting format.

Ideally, investors will closely compare the existing ROIC to the accruing cost of capital.  This allows them to assess a company’s prospective value.  The higher the ROIC value trends, the better the business is performing. 

This value can be further benchmarked against other companies in the same industry, to better assess its effectiveness as an ongoing concern.

As a rule of thumb, if the ROIC is higher than the weighted average cost of capital (WACC), then a surplus in wealth exists.  This means that the organization is proving itself to be productive and is fundamentally a valuable business model.  Investors will pay premium rates to purchase company shares in such high-value businesses.

The most common benchmark used as a weighing measure, is a return of 2% above cost of capital.  Anything less than 2% is perceived as a failing enterprise.

While some firms may actually have a zero-percentile return, they can still be relatively stable.  However, they would nonetheless lack any capital to reinvest in the future expansion and advancement of the company.  This makes them economically vulnerable.

Naturally, there are exceptions to these rules.  Some industries value ROIC more than others due to the nature of their operations. 

Example

A banking institution values its ROIC metrics greatly.  This is because they represent the perceived core operations and growth of the business.  Their publicly traded shares will reflect the ROIC as a direct result of their financial performance.

Conversely, an industrial manufacturer may require intensive reinvestment of their existing capital.  Hence, their own ROIC metrics will be vastly different from the banking institution mentioned prior.  At times, they may be fully invested in acquiring new technology or infrastructure (which will leave them with little liquid capital during a cycle of expansion).  

Key Takeaways

  • The ROIC is always reflected as a numerical percentage.  It represents a trailing 12-month valuation or can serve in an annual reporting format.
  • Ideally, investors will compare the return on invested capital to the cost of capital (when assessing prospective value). 
  • The most common benchmark used as a weighing measure, is a return of 2% above cost of capital.  Anything less than 2% is perceived as a failing or weakened enterprise.
  • Due to the nature of their work, some industries heavily value their perceived ROIC, whereas others do not.
Return On Invested Capital

"The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising because most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration, or, sometimes, institutional politics."

-Warren Buffet, 1987 letter to Berkshire Hathaway shareholders

Advantages of Return on Invested Capital

Used in tandem with other metrics, the return on invested capital can provide a detailed system of analysis.

This makes ROIC an extremely useful tool for prospective investors. 

By using the ROIC and the P/E ratio together, for example, a closer examination of a stock price can take place.  Where the ROIC will provide a sense of how effectively the company is being run, the P/E ratio will signal if the stock is undervalued or priced too high (compared to general market valuations and sentiments).

In comparison, the P/E ratio on its own would give little clue as to the real underlying fundamentals of the business being researched.  Due diligence with only a single metric is quite impossible.  It takes a contrast of information and metrics to accurately assess a company’s standing as an economic engine.

By using the return on invested capital as a foundation for understanding a business, you can then involve other key metrics for comparative analysis.  The broader your research becomes, and the more metrics you make use of, the better your results are likely to be.

Once you have compared a single company thoroughly, you can then analyze its competitors in the same industry.  This will give you useful insights and investment ideas going forward.

Disadvantages of Return on Invested Capital

Return on invested capital is undoubtedly a useful metric for weighing different valuations.  However, it is also somewhat linear in nature.

On its own, the ROIC is a finite resource for understanding a business model.

Moreover, the ROIC cannot deliver details as to which aspect of a business is profitable.  It merely details the overall effectiveness of an operation.

Further, the formulas to determine ROIC valuations lack a coherent standard.  Should you make your own calculation using net income rather than NOPAT, it is likely that you will skew your results.  This is because certain returns may not be recurring, which will obviously create anomalies in future iterations using the same formula.

Earning Release Example of ROIC

This is a company’s first-quarter earnings release.  They detail the prior 12 month’s ROIC by breaking down the metrics of profitability involved in their business.

In either a private or official capacity, this breakdown would look something like this:

(All Valuations In $U.S Millions)

TTM

6/8/20

TTM

6/3/19

Earnings from existing operations – before adjusted interest expenses and income taxation

3,201

3,848

+Operating lease interest*

70

61

-Income taxes

764

1,537

Net operating profit after taxes

2,507

2,372

   

Current portion of long-term debt and other borrowings

170

1,858

+Noncurrent portion of long-term debt

13,174

10,445

-Shareholder Equity

12,054

10,615

+Capitalized operating lease obligations *

1,339

1,187

-Cash and cash equivalents

2,156

2,122

-Net assets of discontinued operations

3

31

Invested capital

19,899

20,451

Average invested capital

20,175

20,894

   

After-tax return on invested capital

12.4%

11.4%

From the depicted first-quarter earnings release, we can garner a deeper understanding of this company’s operations and ROIC.                

To obtain the after-tax return on invested capital, divide the net operating profit after taxes by the average invested capital. 

Both of these metrics can be found in the table above, if you’d like to attempt the formula yourself.

Your formula should look something like this:

Return On Invested Capital

This formula will give you the after-tax return on invested capital.  The higher the after-tax return, the better the outlook for the company will ultimately be.

Note that in the earnings release table above, the after tax return on invested capital has gone up 1% year over year.  This is a good sign for the business, if the trend can continue.

Again, it is always advisable to review a company’s past performance.  This will allow you to assess how stable and sustainable its business model has proven over time.

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