What Is Return on New Invested Capital (RONIC)?
Return on new invested capital (RONIC) is a calculation used by firms or investors to determine the expected rate of return for deploying new capital. A high RONIC indicates a more efficient use of capital, whereas a lower figure may reflect the poor allocation of resources. When new capital is put to work it helps companies fund new products that grow sales and profits.
- Return on new invested capital (RONIC) measures the expected return for deploying new capital.
- RONIC can be calculated by dividing growth in earnings before interest from the previous period to the current period by the amount of net new investments during the current period.
- If RONIC is higher than the weighted average cost of capital the company should deploy new capital.
- RONIC is not the same as return on invested capital (ROIC), where if a company has a steady ROIC then it’s unlikely to need to deploy new capital.
How Return on New Invested Capital (RONIC) Works
Return on new invested capital (RONIC) is a useful metric to compare with the weighted average cost of capital (WACC) of a firm. The latter summarizes the cost of funds acquired through equity or debt issuance. If a company's RONIC, and/or return on invested capital (ROIC) is higher than WACC, the company should move forward with the capital project because it creates value. In other words, a higher return on new invested capital indicates a wide or narrow economic moat.
The calculation specifically measures the returns generated when a company converts its capital into spending to create new value from core operations. A simple formula for return on new invested capital divides growth by investment returns. This is derived from earnings before interest in the current and previous period, and net new investment in the current period. If new capital expenditures (CapEx) fail to facilitate growth, firms should look for a better way to deploy assets.
Companies without a competitive advantage will display similar returns on new invested capital to the weighted average cost of capital. Companies with RONIC below WACC can assume negative earnings before interest growth rates. When the two measures are equal, it suggests a company is unable to invest new capital at a rate of return that exceeds its cost of capital. This means every moat has eroded or is near depletion. Here, the firm might as well payout 100% of earnings as dividends to create value for shareholders. Otherwise, investors would receive tepid share price appreciation with limited fundamental support.
RONIC vs. Return on Invested Capital (ROIC)
Despite sharing similar naming conventions, return on new invested capital is not to be confused with return on invested capital (ROIC). The latter evaluates how efficiently a company allocates its current capital and resources. In practice, ROIC measures the return earned on capital investments for all booked projects.
Calculating ROIC considers four key components: operating income, tax rates, book value and time. The ROIC formula is net operating profit after tax divided by invested capital. Companies with a steady or improving return on capital are unlikely to put significant amounts of new capital work.