Return on invested capital (ROIC) assesses a company’s efficiency in allocating capital to profitable investments. It is calculated by dividing net operating profit after tax (NOPAT) by invested capital.
ROIC provides insights on how effectively a company is using its capital to generate profits. Comparing a company’s ROIC with its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.
Key Insights
- Maximizing Capital Efficiency: ROIC determines how well a company allocates its capital to profitable projects or investments.
- Exploring Profitability: It represents the money a company makes above the average cost for its debt and equity capital.
- Simple Calculation: ROIC is calculated by dividing NOPAT by invested capital.
- Industry Benchmarking: ROIC serves as a benchmark for valuing other companies.
- Value Creation Indicator: A company creates value if its ROIC exceeds its WACC.
The ROIC Formula and Calculation
The ROIC formula is:
ROIC = \frac{NOPAT}{Invested Capital}
Where:
- NOPAT: Net Operating Profit After Tax
Or alternatively:
ROIC = \frac{(net income - dividends)}{(debt + equity)}
Steps to Calculate Invested Capital
- Capital Components: Assess the value of total capital, including debt and equity.
- Adjustment Method: Subtract cash and non-interest-bearing liabilities from total assets.
- Alternative Method: Add the book value of equity to debt and subtract non-operating assets.
- Working Capital Method: Obtain non-cash working capital and add to fixed assets.
Calculating NOPAT
Method 1: Subtract dividends from net income.
Method 2: Adjust operating profit for taxes:
NOPAT = (operating profit) \times (1 - effective tax rate)
Inspirational Example: Target Corporation
Target Corporation calculates its ROIC directly in its annual reports, outlining the components involved. The calculation starts with operating income, adds net other income to get EBIT, adjusts for lease interest, subtracts income taxes, and determines NOPAT. Invested capital includes shareholder equity, debt, and lease liabilities, minus cash.
The Potency of High ROIC
ROIC is an annualized value, used to ascertain whether a company creates value by comparing it with the company’s WACC. Companies with an ROIC exceeding WACC are considered effective in value creation. A two-percentage point premium over WACC usually indicates substantial value generation.
ROIC can vary by sector but remains vital in capital-intensive industries. Companies generating consistent high ROIC often trade at a premium due to better management and profitability.
Limitations of the ROIC metric
While ROIC is vital for valuations, it varies significantly across industries. For capital-intensive sectors like oil or semiconductor manufacturing, ROIC offers crucial insights. However, ROIC alone can’t pinpoint which business segment generates value, and relying solely on net income (minus dividends) can obscure true performance due to extraordinary events.
Understanding Invested Capital
Invested capital is the total money a company raises by issuing securities, summarizing equity, debt, and capital lease obligations. Although not a standalone line in financial statements, it’s derived by aggregating these elements listed separately.
What ROIC Reveals About a Business
ROIC evaluates how a company uses external capital to generate returns. By comparing ROIC to WACC, investors can determine the efficacy of capital utilization. Greater returns showcase value creation potential.
Calculating ROIC
The primary ROIC formula divides NOPAT by invested capital. Deployment of new capital can be evaluated using return on new invested capital (RONIC).
Conclusion
ROIC remains a compelling financial metric revealing how well a company utilizes its capital for creating value. Companies with ROIC exceeding their cost of capital signify sustainable and profitable models. Particularly useful for capital-intensive industries, ROIC aids in comparing similar sector firms, identifying top performers typically trading at a premium.
Related Terms: Net Operating Profit After Tax, Weighted Average Cost of Capital, Invested Capital, ROnic.
References
- NYU Stern School of Business. “Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications”.
- Morgan Stanley. “Return on Invested Capital”.
- Internal Revenue Service. “International Overview Training: Post-2017 Tax Reform”, Pages 4-6.
- SEC. “Form 10-K, Target”, Page 26.
