DEFINITION of 'Return On Invested Capital - ROIC'
A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. Return on invested capital gives a sense of how well a company is using its money to generate returns. Comparing a company's return on capital (ROIC) with its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.
One way to calculate ROIC is:
This measure is also known as "return on capital."
BREAKING DOWN 'Return On Invested Capital - ROIC'
Invested capital, the value in the denominator, is the sum of a company's debt and equity. There are a number of ways to calculate this value. One is to subtract cash and non-interest bearing current liabilities (NIBCL) – including tax liabilities and accounts payable, as long as these are not subject to interest or fees – from total assets.
Another method of calculating invested capital is to add the book value of a company's equity to the book value of its debt, then subtract non-operating assets, including cash and cash equivalents, marketable securities and assets of discontinued operations.
Yet another way to calculate invested capital is to obtain working capital by subtracting current liabilities from current assets. Next you obtain non-cash working capital by subtracting cash from the working capital value you just calculated. Finally non-cash working capital is added to a company's fixed assets, also known as long-term or non-current assets.
The value in the numerator can also be calculated in a number of ways. The most straightforward way is to subtract dividends from a company's net income.
On the other hand, because a company may have benefited from a one-time source of income unrelated to its core business – a windfall from foreign exchange rate fluctuations, for example – it is often preferable to look at net operating profit after taxes (NOPAT). NOPAT is calculated by adjusting the operating profit for taxes: (operating profit) * (1 - effective tax rate). Many companies will report their effective tax rates for the quarter or fiscal year in their earnings releases, but not all. Operating profit is also referred to as earnings before interest and tax (EBIT).
ROIC is always calculated as a percentage and is usually expressed as an annualized or trailing twelve month value. It should be compared to a company's cost of capital to determine whether the company is creating value. If ROIC is greater than the weighted average cost of capital (WACC), the most common cost of capital metric, value is being created. If it is not, value is being destroyed. For this reason ROIC is one of the most important valuation metrics to calculate. That said, it is more important for some sectors than others, since companies that operate oil rigs or manufacture semiconductors invest capital much more intensively than those that require less equipment.
One downside of this metric is that it tells nothing about what segment of the business is generating value. If you make your calculation based on net income (minus dividends) instead of NOPAT, the result can be even more opaque, since it is possible that the return derives from a single, non-recurring event.
ROIC provides necessary context for other metrics such as the P/E ratio. Viewed in isolation, the P/E ratio might suggest a company is oversold, but the decline could be due to the fact that the company is no longer generating value for shareholders at the same rate—or at all. On the other hand, companies that consistently generate high rates of return on invested capital probably deserve to trade at a premium to other stocks, even if their P/E ratios seem prohibitively high.
In Target Corp.'s (TGT) first-quarter 2015 earnings release, the company calculates its trailing twelve month ROIC, showing the components that go into the calculation:
|(All values in million of U.S. dollars)||TTM 5/2/15||TTM 5/3/14|
|Earnings from continuing operations before interest expense and income taxes||4,667||4,579|
|+ Operating lease interest *||90||95|
|- Income taxes||1,575||1,604|
|Net operating profit after taxes||3,181||3,070|
|Current portion of long-term debt and other borrowings||112||1,466|
|+ Noncurrent portion of long-term debt||12,654||11,391|
|+ Shareholders' equity||14,174||16,486|
|+ Capitalized operating lease obligations *||1,495||1,587|
|- Cash and cash equivalents||2,768||677|
|- Net assets of discontinued operations||335||4,573|
|Average invested capital||25,506||25,785|
|After-tax return on invested capital||12.5%||11.9%|
It begins with earnings from continuing operations before interest expense and income taxes ($4,667 million), adds operating lease interest ($90 m), then subtracts income taxes ($1,575 m), yielding a net profit after taxes of $3,181 m: this is the numerator. Next it adds the current portion of long-term debt and other borrowings ($112 m), the noncurrent portion of long-term debt ($12,654 m), shareholders equity ($14,174 m) and capitalized operating lease obligations ($1,495 m). It then subtracts cash and cash equivalents ($2,768 m) and net assets of discontinued operations ($335 m), yielding invested capital of $25,332 m. Averaging this with the invested capital from the end of the prior-year period ($25,680 m), you end up with a denominator of $25,506 m. The resulting after-tax return on invested capital is 12.5%.
This calculation would have been difficult to obtain from the income statement and balance sheet alone, since the asterisked values are buried in an addendum. For this reason calculating ROIC can be tricky, but it is worth arriving at a ballpark figure in order to assess a company's efficiency at putting capital to work. Whether 12.5% is a good result or not depends on Target's cost of capital. Since this is often between 8% and 12%, it is likely that Target is creating value, but slowly and with a thin margin for error.
To learn how to use ROIC for investment selection, please read Find Quality Investments With ROIC.
A class of ownership in a corporation that has a higher claim ...
Long-term debt consists of loans and financial obligations lasting ...
A type of buyer in an acquisition that is primarily interested ...
A company's potential cash earnings if its capitalization were ...
A security that represents ownership in a corporation. Holders ...
1. A company's total earnings (or profit). Net income is calculated ...
Fundamental AnalysisIf you don't know how to evaluate a company's present performance and its possible future performance, you need to learn how to analyze ratios.
Fundamental AnalysisWhen trying to evaluate a company, it always comes down to determining the value of the free cash flows and discounting them to today.
InsuranceFind an investment that will give your portfolio a shot in the arm.
Options & FuturesUse these key attributes to uncover top-level investments.
Options & FuturesReturn on invested capital is a great way to measure the true value produced by a company. Learn to use the ROIC metric and increase your chances of finding successful investments.
MarketsExamine the Flatiron School as it pertains to the product it offers; learn how it monetizes its product and the role the school plays as an industry disruptor.
Stock AnalysisFind out what investors should know before buying Lumber Liquidators shares. Learn about Lumber Liquidators' financial performance and operational outlook.
InvestingCommodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
Stock AnalysisFind out which risks are most important to Amazon's shareholders. Learn which operational risks impact share prices and which financial risks affect investors.
EntrepreneurshipSurprisingly, the younger your company is, the better its numbers may look.
Some of the equity valuation metrics that analysts and investors most commonly use to evaluate companies in the pharmaceutical ... Read Full Answer >>
An annual return can refer to fundamental financial data or income from securities generated by dividends and appreciation. ... Read Full Answer >>
Outside of any limiting, narrow interpretations concerning what constitutes the Internet sector, there is very little industry ... Read Full Answer >>
Warren Buffett and Charlie Munger have long been business partners through Berkshire Hathaway, with the former serving as ... Read Full Answer >>
The return on incremental invested capital (ROIIC) is calculated by dividing a company's constant rate incremental operating ... Read Full Answer >>
Return on invested capital (ROIC) shows the percentage return on money provided by bondholders and shareholders. Examples ... Read Full Answer >>