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Return on Incremental Invested Capital (ROIIC)

Step-by-Step Guide to Understanding Return on Incremental Invested Capital (ROIIC)

Last Updated February 20, 2024

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Return on Incremental Invested Capital (ROIIC)

How to Calculate Return on Incremental Invested Capital (ROIIC)

The return on incremental invested capital (ROIIC), or “incremental return on invested capital”, is the ratio between the change in NOPAT over the course of a given period and the invested capital from the preceding period.

In practice, the incremental return on invested capital measures the operating performance of a company and the long-term sustainability of its business model.

The traditional return on invested capital (ROIC) metric is calculated as NOPAT divided by the average invested capital.

ROIC = NOPAT ÷ Average Invested Capital (IC)
  • NOPAT → NOPAT stands for “Net Operating Profit After Taxes” and represents the operating profits of a company, assuming no financial leverage, i.e. no debt on the balance sheet (and thus, no interest expense). Since NOPAT is a capital structure-neutral measure of profit (and no cash), the metric can be utilized for purposes related to comparability across different companies.
  • Average Invested Capital (IC) → The average invested capital component is the denominator of the ROIC formula. The invested capital can be viewed as the net assets necessary for a business to operate, or the amount of funding required from capital providers to fund the purchase of the net assets.

Conceptually, the return on incremental invested capital (ROIIC) is the return earned on the most recent dollar allocated by a company to fund its growth initiatives.

The timing represented by the metric inputs must be correct – otherwise, the analysis will be misleading – so, it is critical to confirm the correct figures are input into the formula.

In general, companies that exhibit a consistent return on invested capital (ROIC) ahead of their peers are most often capable of outperforming them over the long term in terms of growth and profit margins, which the ROIIC can confirm.

Therefore, the ROIC is more of a historical measure of a company’s efficiency at capital allocation, whereas the ROIIC is more oriented around the efficiency of management’s more recent spending initiatives.

What is the Difference Between ROIC vs. ROIIC?

ROIC and ROIIC are each practical measures to determine the efficiency at which a company’s management team can allocate capital into profitable investments.

  • ROIC → While the ROIC metric is far more commonly used, the implicit assumption that the company’s ROIC will remain constant (or close to it) is one of its shortcomings. The analysis of companies, particularly in the context of corporate valuation, is on a forward-looking basis.
  • ROIIC → Since a company’s current ROIC will inevitably change over the course of time – albeit by how much is unpredictable – the return on incremental invested capital (ROIIC) can be a more practical method to grasp the current state of the company’s efficiency at capital allocation and near-term growth trajectory.

The historical ROIC of a company could perhaps offer useful insights to guide forecast models, yet the assumption that a company’s ROIC will remain constant over the long run is not always a plausible outcome, to say the least.

Therefore, the return on incremental invested capital measures the relationship between the company’s incremental earnings and the incremental spending on investments.

Warren Buffett Quote on Reinvesting Capital

“The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

– Warren Buffett, Berkshire Hathaway (Source: 1992 Shareholder Letter)

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Return on Incremental Invested Capital Formula (ROIIC)

The formula to calculate the return on incremental invested capital (ROIIC) is as follows.

Return on Incremental Invested Capital (ROIIC) = (NOPAT t=2 NOPAT t=1) ÷ (Invested Capital t=1 Invested Capital t=0)


  • NOPAT = EBIT × (1 – Cash Tax Rate)

The periodicity of the invested capital component of the formula is deliberately a “step behind” the time frame covered by NOPAT, since investments often require time before the positive monetary effects materialize.

Learn More → Capital Allocation (Source: Credit Suisse)

What is a Good ROIIC Ratio?

So, what is the target ROIIC ratio that corporations tend to target?

Simply put, a higher incremental return on invested capital implies the company’s management team is efficient at capital allocation and can obtain strong returns from its investments, such as corporate initiatives that pertain to growth and market expansion.

The ROIIC metric is therefore a practical method to estimate the trajectory of a company’s future revenue generation and profit margin expansion in the coming years, i.e. the remaining “upside” potential.

From the perspective of long-term investors in the public markets, identifying a public company with an ROIC that consistently exceeds that of its peers – along with an ROIIC to reaffirm management can still reinvest capital efficiently to earn high rates of return going forward – is most likely a stock worth taking a risk on.

However, companies with volatile performance with regard to their operating profitability, or cyclical spending patterns, should measure their ROIIC on a rolling 3-to-5-year basis.

But to reiterate, strong ROIC performance in historical periods is not enough on its own for a business to establish a moat, which coincides with long-term profit margin and market share protection from the possession of a differentiating factor (and competitive advantage) that can act as a deterrent to existing competitors and new market entrants.

Learn More → Return on Invested Capital (ROIC) (Source: Morgan Stanley)

Illustrative ROIIC Calculation Example

To quickly illustrate the incremental return on invested capital (ROIIC) concept, assume a corporation spent a total of $10 million at the start of Year 1, which soon after grew to 12 million within the next twelve months.

On the other hand, the NOPAT of the company was $2 million as of Year 0, but the past spending enabled the company’s NOPAT to expand to $2.5 million.

Given those assumptions, the incremental return on invested capital (ROIIC) is 25%.

  • Return on Incremental Invested Capital (ROIIC) = ($2.5 million – $2 million) ÷ ($12 million – $10 million)
  • ROIIC = 0.25, or 25%

ROIIC Calculator

We’ll now move to a modeling exercise, which you can access by filling out the form below.


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Return on Incremental Invested Capital Calculation Example (ROIIC)

Suppose we’re tasked with calculating the 3-year return on incremental invested capital (ROIIC) of Microsoft (MSFT).

Before we delve into the modeling exercise, we’ll clarify our assumptions:

  • Minimum Cash Balance → The cash balance stated on our model reflects the minimum cash – i.e. the bare minimum of cash on hand for the business to continue operating – which we assumed to be 2.0% of revenue in each period. The reason behind the assumption is to analyze the return without the distortive impact of excess cash sitting idle on a company’s balance sheet. The “excess” cash is NOT part of the core operations of the business model, so its inclusion can be misleading and prevent the accurate appraisal of management’s aptitude for capital allocation.
  • Exclusion of Interest-Bearing Securities → Any short-term investments that can generate a yield, such as marketable securities, is neglected in the calculation. Likewise, all forms of debt and interest-bearing liabilities are also excluded because such items are more reflective of financing activities, rather than operating activities.

Because of the fact that the effects of non-operating items were intentionally removed, the implied return will likely be on the higher end. The more important point, however, is to ensure consistency in all comparisons and to apply the same methodology for other comparable companies.

In the first step, we’ll start by calculating the minimum cash balance for each period, which we’ll accomplish by multiplying the hard-coded revenue input by our 2.0% assumption.

From that point, the “Total Current Assets” line item will be determined by calculating the sum of all current assets, including the minimum cash balance.

Current Assets Section
($ in millions) 2018A 2019A 2020A 2021A 2022A
Minimum Cash $2,207 $2,517 $2,860 $3,362 $3,965
(+) Accounts Receivable 26,481 29,524 32,011 38,043 44,261
(+) Inventories 2,662 2,063 1,895 2,636 3,742
(+) Other Current Assets 6,751 10,146 11,482 13,393 16,924
Total Current Assets $38,101 $44,250 $48,248 $57,434 $68,892

In the next step, we’ll compute the net working capital (NWC) for each fiscal year by deducting the current liabilities – net of any interest-bearing securities – from the total current assets balance.

Once the net working capital (NWC) is determined for each period, the remaining step to arrive at the invested capital (IC) line items is to add the long-term assets that belong to Microsoft.

Invested Capital (IC) Calculation
($ in millions) 2018A 2019A 2020A 2021A 2022A
Total Current Assets $38,101 $44,250 $48,248 $57,434 $68,892
(–) Non-Interest-Bearing Current Liability (NIBCL) (54,490) (63,904) (68,561) (80,585) (92,333)
Net Working Capital (NWC) ($16,389) ($19,654) ($20,313) ($23,151) ($23,441)
(+) Property and Equipment, net 29,460 36,477 44,151 59,715 74,398
(+) Operating Lease, Right-of-Use Assets 6,686 7,379 8,753 11,088 13,148
(+) Goodwill 35,683 42,026 43,351 49,711 67,524
(+) Intangible Assets, net 8,053 7,750 7,038 7,800 11,298
(+) Other Long-Term Assets 7,442 14,723 13,138 15,075 21,897
Invested Capital (IC) $70,935 $88,701 $96,118 $120,238 $164,824

The denominator of our formula, the invested capital (IC), is complete, so the next step is to compute NOPAT using the historical financial data of Microsoft (MSFT).

Since we’re measuring the operating performance of Microsoft for past periods, as opposed to building a forecast model, NOPAT will be calculated by deducting EBITA – i.e. “Earnings Before Interest, Taxes, and Amortization” – by income taxes and deferred taxes.

NOPAT Calculation
($ in millions) 2018A 2019A 2020A 2021A 2022A
EBITA $37,676 $45,476 $55,506 $72,823 $86,792
(–) Taxes (19,903) (4,448) (8,755) (9,831) (10,978)
(–) Deferred Taxes (5,143) (6,463) 11 (150) (5,702)
NOPAT $12,630 $34,565 $46,762 $62,842 $70,112

Once the two schedules within our model are complete, we arrive at a 3-year incremental return on invested capital of 72.1% using the following formula:

  • Incremental Return on Invested Capital (ROIIC) = ($70,112 million – $34,565 million) ÷ ($120,238 million – $70,935 million)
  • ROIIC = 72.1%

Incremental Return on Invested Capital (ROIIC)

Return on Incremental Invested Capital Example

Microsoft 3-Year Return on Incremental Invested Capital (Source: Morgan Stanley)

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