Return on invested capital (ROIC) is a way of measuring the efficiency of a company. It indicates the company’s overall income and profitability as a ratio of each dollar of underlying capital. If the company’s ROIC exceeds 2% (background inflation), the company is considered an efficient value-creator. It is turning invested capital into growth that exceeds the background value of money. If the company’s ROIC is below 2% (and particularly if it is below 1%), the company is considered a value-destroyer. Here’s what you need to know.
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What Is Return on Invested Capital?
Return on invested capital, or “ROIC,” is a performance ratio used to evaluate how well a company uses its underlying capital. The ratio attempts to show how well the company turns capital into income.
A high ratio suggests that the company is very efficient, and turns each dollar of underlying capital into significant growth and earnings. A low ratio suggests that the company is very inefficient, turning each dollar of capital into less than a dollar of growth.
An ROIC analysis is used to analyze a company’s performance from an investor’s point of view. Typically, a company is considered a value-creator if it has a ROIC ratio higher than 2%. At this rate, the ROIC suggests that the company generates earnings higher than the rate of inflation. This means that, as an investor, your capital will likely grow faster than the value of money. Below this rate, and the company is considered inefficient, because it is losing value for each dollar of underlying capital.
From there, an investor can then compare the ROIC of multiple different companies. Each firm’s return ratio suggests the likely performance of an invested dollar. As an investor, this can help you determine which companies are likely to be a stronger investment.
How to Calculate ROIC
The ROIC formula is relatively simple on its face:
- ROIC = Net Operating Profit After Tax / Invested Capital
Calculating NOPAT
Net operating profit after tax (NOPAT) measures a company’s profits after paying taxes, but before paying interest on current debt. This figure is calculated based on a company’s EBIT and its marginal tax rate. The NOPAT formula is:
- NOPAT = EBIT * (1 – Tax Rate)
A company’s EBIT stands for Earnings Before Interest and Taxes. Broadly, this is based on the company’s earnings, less its operating costs. What is left is the firm’s operating profit before accounting for its cost of capital and taxes.
You can find a company’s EBIT published on its earnings statement. This is a standard disclosure for publicly traded companies. A company’s marginal tax rate accounts for its entire taxation, meaning federal, state and local. Make sure to account for all applicable taxes in the analysis, otherwise your ROIC might come out artificially high.
For example, say that you have a company with the following disclosures:
- EBIT (Operating Profits) – $100 Million
- Total Tax Rate – 20%
The company’s net operating profit after tax (NOPAT) would be:
- NOPAT = $100 Million * (1 – 0.2) = $100 Million * 0.8 = $80 Million
Calculating Invested Capital
Invested capital is more difficult to calculate. Broadly, there are two ways to determine a company’s underlying invested capital:
- Market Financing
- Total Assets
With the market financing method, you calculate invested capital based on all of a company’s debt and equity financing. For example, you might use the firm’s entire market capitalization plus all of its long-term borrowing, and use that as the firm’s total investment.
The market financing method can be disfavored because it introduces uncertainty into the analysis. An ROIC ratio is meant to show how well a company is using each dollar of underlying investment. However, equity investment and lending terms tend to incorporate future expectations, and a company’s share price on the secondary market does not necessarily reflect its actual capitalization. This can distort your ROIC analysis, since your invested capital figure will be skewed low or high based on market speculation.
Instead, most analysts prefer to use a company’s total assets as the underlying investment capital. For many companies you can find the total assets, otherwise known as the company’s “book value,” in its financial disclosures. Failing that, you can calculate a company’s book value based on the sum total of its:
- Working capital (defined as cash, less non-interest bearing liabilities currently due)
- Physical assets (including all buildings, vehicles, equipment, and other property)
- Intangible assets (including good will and intellectual property)
Book value is considered a more reliable figure for invested capital. While it’s difficult to accurately value and capture all of a company’s assets, this figure still gives you a more accurate sense of how much money a company is using to operate and finance its operations. That, in turn, gives you a better sense of the ratio at which it is turning capital into after-tax operating profits.
An Example of Return on Invested Capital
Let’s look at an ROIC analysis through a hypothetical company ABC Corp. This company has the following financials:
- EBIT: $50 Million
- Tax Rate: 20%
- Total Assets: $250 Million
- Borrowed Capital: $40 Million
- Payroll Costs: $10 Million
First, we calculate ABC Corp.’s NOPAT.
- NOPAT = EBIT * (1 – Tax Rate)
- NOPAT = $50 Million * (1 – 0.2)
- NOPAT = $40 Million
Then we calculate ABC Corp.’s book value:
- Book Value = Total Assets + Working Capital – Non-Interest Liabilities
- Book Value = $250 Million + $40 Million – $10 Million
- Book Value = $280 Million
The loan capital is included in the company’s working capital, but we reduce the book value by ABC Corp.’s upcoming payroll (so, non-interest) payments.
Then we calculate the ROIC. It tells us how much money ABC Corp. is making based on the underlying capital that it has to use:
- ROIC = NOPAT / Invested Capital
- ROIC = $40 Million / $280 Million
- ROIC = 0.14 = 14%
ABC Corp. has a ROIC of 14%. This gives it a rate of return considerably above the rate of inflation. This makes ABC Corp. generally a good investment. On the other hand, say that ABC Corp. has a considerably different book value:
- ROIC = NOPAT / Invested Capital
- ROIC = $40 Million / $6 Billion
- ROIC = 0.006 = 0.6%
In this situation, ABC Corp. has an ROIC of 0.6%. Not only is this below inflation, but it’s below 1%. This indicates that ABC Corp. is a bad investment, because it simply isn’t doing that much with the $6 billion that investors have handed to it. The company is not likely to generate profits from any given dollar invested or lent to it.
Bottom Line
Return on invested capital (ROIC) is a ratio that measures how well a company is using its assets. A strong ratio suggests that the company is creating value from its underlying investments, while a weak ratio suggests that the company is losing value.
Tips On Using Technical Indicators
- Return on invested capital is what’s called a technical indicator, which is one way to evaluate a stock. Here’s an overview of how technical analysis is used to make investment decisions.
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