Return on Incremental Invested Capital (ROIIC)

Return on Incremental Invested Capital Formula (ROIIC)

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

Where:

• 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.

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.

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.

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%

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