Return On Invested Capital - ROIC

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What is '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:

Return On Invested Capital (ROIC)

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
Invested capital 25,332 25,680
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.