What Is Return on Invested Capital (ROIC)?
Return on invested capital (ROIC) is a calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ROIC gives a sense of how well a company is using its capital to generate profits. Comparing a company's return on invested capital with its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.
- Return on invested capital (ROIC) is the amount of money a company makes that is above the average cost it pays for its debt and equity capital.
- The return on invested capital can be used as a benchmark to calculate the value of other companies.
- A company is thought to be creating value if its ROIC exceeds its weighted average cost of capital (WACC).
The Return On Invested Capital (ROIC)
Formula and Calculation of Return on Invested Capital (ROIC)
The formula for ROIC is:
ROIC=Invested CapitalNOPATwhere:NOPAT=Net operating profit after tax
Written another way, ROIC = (net income – dividends) / (debt + equity). The ROIC formula is calculated by assessing the value in the denominator, total capital, which is the sum of a company's debt and equity.
There are several 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.
A third method of calculating invested capital is to add the book value of a company's equity to the book value of its debt and then subtract non-operating assets, including cash and cash equivalents, marketable securities, and assets of discontinued operations.
A final way to calculate invested capital is to obtain the working capital figure 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.
An ROIC higher than the cost of capital means a company is healthy and growing, while an ROIC lower than the cost of capital suggests an unsustainable business model.
The value in the numerator can also be calculated in several 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:
NOPAT = (operating profit) x (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 companies do this—meaning it may be necessary to calculate the rate by dividing a company's tax expense by net income.
What ROIC Can Tell You
ROIC is always calculated as a percentage and is usually expressed as an annualized or trailing 12-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 a firm's weighted average cost of capital (WACC)—the most commonly used cost of capital metric—value is being created and these firms will trade at a premium. A common benchmark for evidence of value creation is a return of two percentage points above the firm's cost of capital.
Some firms run at a zero-return level, and while they may not be destroying value, these companies have no excess capital to invest in future growth.
ROIC is one of the most important and informative valuation metrics to calculate. However, 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.
Limitations of ROIC
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 the return may derive from a single, non-recurring event.
ROIC provides the necessary context for other metrics such as the price-to-earnings (P/E) ratio. Viewed in isolation, the P/E ratio might suggest a company is oversold, but the decline could be because 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 compared to other stocks, even if their P/E ratios seem prohibitively high.
Example of How to Use ROIC
The ROIC calculation begins with operating income, then adds nets other income to get EBIT. Operating lease interest is then added back and income taxes subtracted to get NOPAT. Target's invested capital includes shareholder equity, long-term debt, and operating lease liabilities. Target subtracts cash and cash equivalents from the sum of those figures to get its invested capital.
What Is Invested Capital?
Invested capital is the total amount of money raised by a company by issuing securities—which is the sum of the company's equity, debt, and capital lease obligations. Invested capital is not a line item in the company's financial statement because debt, capital leases, and stockholder’s equity are each listed separately on the balance sheet.
What Does Return on Invested Capital Tell You?
Return on invested capital (ROIC) determines how efficiently a company puts the capital under its control toward profitable investments or projects. The ROIC ratio gives a sense of how well a company is using the money it has raised externally to generate returns. Comparing a company's return on invested capital with its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.
How Do You Compute ROIC?
The ROIC formula is net operating profit after tax (NOPAT) divided by invested capital. Companies with a steady or improving return on capital are unlikely to put significant amounts of new capital to work.