What is Return on Invested Capital (ROIC)?

The return on invested capital is like a fuel efficiency rating for a car...

If you put in X amount of gas, how many miles will the car go? That’s what a fuel efficiency rating will tell you. If you put in X amount of capital, how much in returns will a company deliver? In theory, that’s what ROIC will tell you. Like a fuel efficiency rating helps you compare cars when shopping around, ROIC lets you compare investments.

Companies use capital to grow and generate income. The return on invested capital (ROIC) lets the company and other stakeholders estimate how much profit the company is creating for every dollar of invested capital.

ROIC is often used as a measure of management’s performance because it shows how efficiently management uses money raised through equity and debt to turn a profit.

The ROIC formula is net operating profit after tax (NOPAT) divided by the invested capital.

• NOPAT is after-tax company earnings.
• Invested capital comes from two sources: debt and equity.

Typically, the ROIC is used to measure how much money you would get for investing one dollar in a company. For example, a 12% ROIC tells you that for every dollar you might put in a company, you would receive 12 cents in income.

Investors observing an ROIC typically look at the trend of the ROIC over a period to assess the potential and consistency of an investment in a company.

So, a company with a steadily climbing ROIC over several years may appear as a better investment than others with a declining or unstable ROIC over the same period.

Investment returns, of course, are never guaranteed.

Additionally, an investor can gain additional insights by comparing a company’s ROIC against that of its competitive set or industry as a whole.

Another important use of the ROIC is to compare it to the same company’s weighted average cost of capital (WACC) — a weighted measure of the cost of capital provided by shareholders and debtholders.

By comparing the ROIC to the weighted cost of capital from all sources, you can determine whether the company is considered a value creator or a value destroyer, and put a valuation on that growth potential.

When a company’s ROIC is greater than the WACC, the company is referred to as a value creator (some investors use WACC +2% to be conservative). Investors often consider it prudent to reinvest the excess returns into the company to sustain further growth.

Alternatively, a company with an ROIC smaller than the WACC suggests to investors that the company is a value destroyer and that the invested capital could be put into more efficient use.

In summary:

• ROIC > WACC: Value creator — the company is efficiently using its capital to generate excess returns and typically trades at a premium price.
• ROIC < WACC: Value destroyer — the company is inefficiently using its capital and generates subpar returns (equal or less than the cost of capital). The company often trades at a discount.

While return on capital employed (ROCE), return on investment (ROI), and return on equity (ROE) are similarly-sounding financial ratios to return on invested capital (ROIC), there are essential differences between ROIC and each one of them.

The principal difference between ROIC and return on capital employed (ROCE) is the type of capital used as a denominator in its calculation. While the ROIC divides the net operating profit by the invested capital, the ROCE divides the net operating profit by the capital employed.

Invested capital is a subset of capital employed, as the latter is more comprehensive. Another difference is that ROCE generally uses after-tax book values, and the ROIC often uses pre-tax amounts.

While the ROIC considers all of the activities a company undertakes to generate a profit, the return on investment (ROI) focuses on a single activity. You get the ROI by dividing the profit from that single activity (gain – cost) by the cost of the investment.

Another difference is that the ROIC is typically calculated over a 12-month period, while the ROI doesn’t have a standard time period for calculations.

The return on equity (ROE) tells you how much profit a company is earning relative to the value of assets after subtracting debts. Unlike ROE, ROIC focuses on the profits generated by both equity and debt.

To calculate the ROIC of a company, you use the book value of items from the balance sheet and the income statement in the following formula:

There are a couple of approaches to calculate both NOPAT and IC. Here are the typical approaches to calculate each item:

• NOPAT = earnings before interest and taxes (EBIT) x (1 – tax rate)
• IC = Book value of debt + Book value of equity – Goodwill – Cash

where t indicates the current period, and t-1 indicates the previous period.

A good ROIC is typically one that exceeds the company’s weighted average cost of capital (WACC) by at least 2%.

While it’s generally considered good for a management team to be able to use capital resources from investors and debtholders to generate a profit, those investors are also looking for the management team to make efficient use of capital. An ROIC that exceeds the WACC by at least 2% signals that management is using funding efficiently to turn a profit and that management should reinvest excess returns in the company to fuel its future growth.

ROIC can be improved by expanding the ROIC formula using company sales and determining a company’s competitiveness.

Each one of the ratios tracks one aspect of competitiveness from the company.

The NOPAT / Sales ratio is a measure of the profit margin, and the Sales / IC ratio is one measure of capital efficiency.

By further breaking down the ROIC, you can understand the reason behind a company’s performance. Companies often keep track of the profit margin ratio and the capital efficiency ratio over several quarters to understand how operating changes affect the ROIC.

The tracking of ROIC over time through both rates allows the company to better understand how it can “tweak” its operations to make more efficient use of its capital.

There are three key requirements for ROIC calculation.

• Using after-tax operating income: All income must be after taxes because it has to consider that return to investors and bondholders is subject to applicable taxes.
• Using book value instead of market value: ROIC takes a look at past performance. You can’t use market values because they take into account expectations about future performance.
• Using different time periods: Before your capital can generate returns, you have to invest it. Therefore, invested capital is from a previous period than the one from the NOPAT.

ROIC is a useful measure of company performance, but it has some shortcomings. Its main disadvantage is that it is an accounting measure, meaning that it can be intentionally manipulated through different accounting practices.

There are different accounting practices accepted by law, and a company’s management may choose the one that provides the best results for ROIC and other financial ratios.

Additionally, the ROIC is susceptible to significant one-time expenses (e.g., an organization-wide restructuring) or revenues (e.g., an extraordinary benefit from a currency fluctuation). Some ROICs should be put into context and may have to be recalculated without the one-time expense or revenue.