Return on invested capital (ROIC) is a financial metric that shows how well a company converts capital into profits. It measures the company’s efficiency and effectiveness at allocating its available capital to projects, products and investments that produce profits. Investors use ROIC to assess a company’s profitability and ability to create value. ROIC can be boosted by increasing profits, selling unproductive assets, speeding up inventory turnover and improving their capital structure.
A financial advisor can explain how metrics such as ROIC can guide your investment choices.
What Is ROIC?
Return on invested capital (ROIC) measures the amount of profit a company earns from the capital it receives from investors who own its stock and buy its bonds. It is an important financial metric, expressed as a percentage, that indicates how effective and efficient a company is at generating profits by selecting the best places to invest its available capital.
ROIC is one of a number of metrics investors use, each of which provides a distinct insight into a company’s financial health. Return on investment (ROI), for instance, compares an investment’s earnings to the cost of the investment. The difference between these two is that ROIC measures how well a company is doing in allocating its capital in ways that produce profits, while ROI looks at the gain on an investment compared to its cost to the investor.
Why ROIC Matters
ROIC measures a company’s ability to generate free cash flow, which is an important metric for investors to determine company value. The average ROIC is about 9.13%, according to a New York University analysis. A high ROIC can indicate that company is more valuable than a similar firm with a lower ROIC. A higher ROIC can lead to higher stock prices.
ROIC is also used to benchmark companies. By comparing ROICs among competitors, an analyst can get an idea of how well-run a company is versus its peers.
How to Calculate ROIC
Calculating ROIC involves dividing net operating profit after tax (NOPAT) by the amount of capital invested. NOPAT is the amount of operating profit the company has when adjusted for taxes. Capital invested is the total amount of money investors have given the company in exchange for its shares and debt instruments, such as bonds.
The formula looks like this:
ROIC = NOPAT / Invested Capital
For example, a company that produced a $1 million annual NOPAT while investing $5 million during that year would have an ROIC of 20%. An average of the profits and capital invested over several years can also be used to generate an ROIC reflective of longer-term trends.
Interpreting ROIC
Generally speaking, a company with a higher ROIC has the potential to generate more profit and cash flow and be worth more than a comparable company with a lower ROIC. A company with a lower ROIC will have to invest a larger percentage of its earnings in order to maintain a similar growth rate.
Investors generally look for companies with higher ROICs than their peers. They also look for companies whose ROIC is higher than its cost of capital.
ROICs can vary by industry, however, so comparing companies across industries will not necessarily yield useful information. For example, a pharmaceutical firm will generally have a higher ROIC than an electric utility.
Improving ROIC
Improving profits generally boosts ROIC. This can involve increasing sales, reducing costs or a combination of both. Firms can increase sales by various means, including selecting products, projects or investments that will be in higher demand from customers. They can reduce costs by, among other techniques, negotiating lower-cost contracts from suppliers, achieving operational efficiencies or using less expensive components.
ROIC can also be increased by reducing the use of capital. This can be accomplished by selling under-performing assets, speeding inventory turnover or modifying the firm’s capital structure to employ a more optimal mix of debt and equity.
Bottom Line
Return on invested capital (ROIC) can be used to identify investment opportunities in companies that are highly efficient at turning capital received from shareholders and bondholders into profits. It’s calculated by dividing net operating profit after tax (NOPAT) by the amount of invested capital. ROIC varies widely by company and across industries.
Tips on Investing
- There are many financial metrics that you can use to help with financial decisions. A financial advisor can show which ones are relevant to any particular decision and how to apply them. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Companies use metrics like ROIC to measure their performance. The performance of your investment portfolio can be projected with SmartAsset’s Investment Return and Growth Calculator. By entering the amount in dollars you are starting with, the amount and time schedule for any additional contributions and the anticipated rate of return, you can see how your investment will grow over time much your portfolio will be worth at a given point in the future.
Photo credit: ©iStock.com/Milan_Jovic, ©iStock.com/recep-bg, ©iStock.com/ronstik