## What is ROIC?

The **Return on Invested Capital (ROIC)** measures the percentage return of profitability earned by a company using the capital contributed by equity and debt providers.

Conceptually, the return on invested capital (ROIC) is a measure of value creation. In practice, ROIC is commonly used to determine the efficiency at which capital is allocated because the consistent generation of a positive value is perceived positively as a necessary attribute of a quality business.

- ROIC stands for “Return on Invested Capital” and measures the efficiency at which a company can spend the capital contributed by shareholders and lenders to generate returns.
- The ROIC is a profitability ratio that measures the efficiency at which a company’s management can allocate capital, which ultimately determines the long-term sustainability of the business model.
- The ROIC is the rate of return earned by a company from reinvesting the funds contributed by its capital providers, i.e. equity and debt investors.
- The formula to calculate ROIC is NOPAT divided by the average invested capital, i.e. the company’s fixed assets and net working capital (NWC).

## How to Calculate ROIC

ROIC, or “Return on Invested Capital”, represents the efficiency at which a company uses its capital to generate profitable returns on behalf of its shareholders and debt lenders.

Fundamentally, the return on invested capital (ROIC) answers the question, *“How much in returns is the company earning per dollar of invested capital?”*

**Therefore, the ROIC concept reflects the rate of return generated by a company using the funds contributed by its capital providers.**

Since the return metric is presented in the form of a percentage, the metric can be used to assess a company’s profitability as well as make comparisons to peer companies.

For companies attempting to raise capital from outside investors for the first time or raise additional funding, the ROIC is a critical KPI that can serve as validation (i.e. a track record of “proof”) that management is competent and can be relied upon to pursue and capitalize on profitable opportunities.

The return on invested capital (ROIC) calculation comprises the following steps:

**Step 1 ➝**Compute NOPAT (or EBIAT)**Step 2 ➝**Calculate Average Invested Capital (IC)**Step 3 ➝**Divide NOPAT by Average Invested Capital

## ROIC Formula

The formula used to calculate ROIC is the ratio between net operating profit after tax (NOPAT) and average invested capital (IC).

**Return on Invested Capital (ROIC) =**NOPAT

**÷**Average Invested Capital

Where:

NOPAT is used in the numerator because the cash flow metric captures the recurring core operating profits and is an unlevered measure (i.e. unaffected by the capital structure). Unlike metrics such as net income, NOPAT is a company’s tax-affected operating profit (EBIT) and thus represents what is available for all equity and debt providers.**Net Operating Profit After Tax (NOPAT) ➝****Invested Capital (IC) ➝**As for the denominator, the invested capital represents the sources of funding raised to grow the company and run the day-to-day operations.

The ROIC ratio quantifies the profits that the company can generate for each dollar of capital invested in the company in a percentage.

The two common sources of funds for companies that are used to invest in cash flow generative assets and derive economic benefits are debt and equity.

**Debt Financing**➝ The capital obtained by a company in exchange for the obligation to pay periodic interest expense throughout the borrowing term and the return on the original principal at maturity.**Equity Financing**➝ The capital raised by a company by issuing ownership stakes, i.e. shares representing partial ownership, to institutional investors such as venture capital or growth equity firms, or the secondary markets if the company is publicly traded.

## ROIC Example

Suppose a company generated $10 million in NOPAT in Year 1 and invested an average of $100 million from the end of Year 0 to the end of Year 1.

- NOPAT = $10 million
- Average Invested Capital (IC) = $100 million

Given the NOPAT and average invested capital, the ROIC comes out to 10%.

- Return on Invested Capital (ROIC) = $10 million ÷ $100 million = 10.0%

The 10% ROIC implies that the company generates $10 of net earnings per $100 invested in the company.

## What is Invested Capital in ROIC?

The two core components of the ROIC calculation are NOPAT and invested capital.

**NOPAT**➝ NOPAT, or “EBIAT,” is the tax-affected operating income (EBIT) of the company**Invested Capital (IC)**➝ Invested capital, on the other hand, is the sum of fixed assets, net working capital (NWC), and acquired intangibles, including goodwill.

The formula to calculate NOPAT and invested capital is as follows.

- NOPAT = EBIT × (1 – Tax Rate %)
- Invested Capital = Fixed Assets + Net Working Capital (NWC) + Acquired Intangibles + Goodwill

The calculation of NOPAT is relatively straightforward since EBIT (or “operating income”) is taxed as if there is no debt in the company’s capital structure (and, thus, no interest expense).

In contrast, invested capital (IC) can become a rather onerous calculation.

There are two routes to think about invested capital, but either approach is ultimately identical to the other due to double-entry accounting.

**Net Working Capital (NWC)**➝ The net assets that a business needs to continue operating day-to-day.**Capital Expenditure (Capex)**➝ The funding provided by creditors and shareholders to finance the purchase of the company’s assets, which can be categorized as either growth or maintenance capex.

The alternative, simpler method of calculating invested capital is to calculate net debt—which is equal to gross debt subtracted by cash and cash equivalents—and add net debt to equity from the balance sheet.

**Cash and Cash Equivalents**➝ Since cash and cash equivalents (e.g. marketable securities) are not operating assets, the line item is thus excluded. Cash is considered to be “sitting idle” on the B/S and is thus not part of the core operations of a company.**Debt and Interest-Bearing Securities**➝ A similar logic is applied to debt and interest-bearing securities, which are not considered operating liabilities, either. Hence, the appropriate treatment of those sorts of borrowings is to ignore them in the computation.

The complications with invested capital (IC) arise for intangible-intensive industries, in which the intangible assets belonging to the companies that operate in the industry are not recognized yet.

While the inclusion of acquired intangibles and goodwill – the premium paid in excess of the fair value of the acquired assets – is intuitive since such corporate actions reflect the capital allocation of management (i.e. the decision to pay a premium counts), the value attributable to unacquired intangible assets is far more challenging.

One method is to capitalize intangible investments—i.e. the incurred research and development (R&D) expense—but the issue is that the subjective adjustments make the ROIC metric less reliable as a measure of comparability.

Why? There is less standardization, and the comparisons can easily become distorted from the discretionary adjustments.

## What is a Good ROIC Ratio?

The return on invested capital (ROIC) is one method to determine whether or not a company has a defensible economic moat.

The term “moat” refers to a sustainable competitive advantage belonging to a particular business that protects its long-term profit margins and market share from new market entrants (and other external threats) over the long run.

The overall objective of calculating the metric is to grasp a better understanding of how efficiently a company has been utilizing its operating capital (i.e. capital deployment).

For investors in the public markets, the metric is frequently used to screen for potential investments, not just for retail investors but for institutional investors such as hedge funds – especially funds utilizing long-only, value-oriented strategies.

^{Warren Buffett Quote on Economic Moats (Source: 2007 Berkshire Hathaway Shareholder Letter)}

Finding public companies in the stock market with an actual “moat” and consistently above-market ROICs is, without a doubt, easier said than done, but one that can yield high investment returns.

The reason the ROIC concept tends to be prioritized by value investors is that most investors purchase shares under the mindset of a long-term holding period.

Hence, current earnings and cash flows are a relatively small component of the total net return. Instead, the ability to reinvest those earnings to build real value is much more important.