Return on Invested Capital (ROIC)

ROIC vs. ROCE: What is the Difference?

The return on invested capital (ROIC) and return on capital employed (ROCE) are returns-based metrics used to analyze the profitability of a company and the efficiency at which its management team allocates capital.

• Return on Invested Capital (ROIC) ➝ The distinction between ROIC and ROCE is that the numerator in the ROIC formula is NOPAT, whereas the denominator is invested capital.
• Return on Capital Employed (ROCE) ➝ On the other hand, the numerator in ROCE is also NOPAT, but the denominator is capital employed.

Where:

• Capital Employed = Total Assets – Current Liabilities

Therefore, ROIC and ROCE offer different perspectives on a company’s operating efficiency and capital allocation.

ROIC vs. WACC: What is the Difference?

One common way to use ROIC as an investment decision-making tool is to compare the investment’s ROIC to its weighted average cost of capital (WACC).

Comparing the ROIC to the WACC can help decide whether the company creates sufficient value for its stakeholders.

If the ROIC is higher than the WACC, that means the company creates positive value, whereas if the ROIC is lower than the WACC, that means the company’s value is declining.

• If ROIC > WACC → “Invest”
• If ROIC < WACC → “Pass”

Companies that generate an ROIC above their cost of capital imply that the management team can allocate capital efficiently and invest in profitable projects, which is a competitive advantage in itself.

When investors screen for potential investments, the minimum ROIC tends to be set between 10% and 15%, but that threshold will be firm-specific and will depend on the type of strategy employed.

One of the more frequent use cases of tracking the metric is for evaluating the judgment of the management team regarding capital allocation.

Namely, there are five methods for corporations to improve their ROIC and thus create positive economic value over the long run:

1. Invest in High Return, Profitable Projects ➝ ROIC > WACC (“Value Creating”)
2. Improve Capital Efficiency ➝ Higher Asset Turnover, Higher Inventory Turnover, Revenue Maximization
3. Implement Operating Improvements ➝ Higher Profit Margins, Reduce Unnecessary Spending
4. Optimize Capital Structure ➝ Potentially Lower WACC from Issuance of Debt
5. Identify and End “Value Destroying” Projects ➝ NPV < 0

Learn More → ROIC by Sector (Source: Damodaran)

What are the Full-Form ROIC Components?

From the expanded full-form formula of ROIC, we can see the value is the product of:

• Invested Capital Turnover ➝ “How much revenue does each dollar of invested capital generate?”
• Margins (%) ➝ “How much profits are retained after deducting the cost of goods sold (COGS) and operating expenses (OpEx) to arrive at operating income (EBIT), which is then tax-affected?”

The underlying components of the ROIC metric, at its core, are reflected in the following equation.

NWC affects invested capital since if operating assets increase, invested capital increases as well – which in turn decreases the metric (i.e. more spending is needed to sustain or increase growth).

Conversely, if operating liabilities were to increase, ROIC would increase because NWC is lower.

A higher return on invested capital (ROIC) can be considered an indication that a company is required to spend less to generate more profit.

• Profitable Return on Invested Capital → Positive Value Creation and Shareholder Returns

The higher the profit margins of the company, the higher the return on invested capital, as the company can convert more revenue into profits, or NOPAT, to be more specific.

How to Analyze ROIC and Growth

Contrary to a common misunderstanding, growth is not always a positive signal for a company.

The question that must be asked is, “At what cost was the growth obtained?”

Often, companies will make significant investments to expand, but if the ROIC is lower than the cost of capital (WACC), the Capex destroys value, not creating shareholder value.

• Scenario A ➝ In Scenario A, the change in invested capital was $25m more, for an increase of $5m in NOPAT.
• Scenario B ➝ In contrast, in Scenario B, the NOPAT increased by $5m too, but $150m was spent. Therefore, focusing on growth in NOPAT by itself would be misleading in the latter case.

How to Balance ROIC with Growth and Value Creation

Generally speaking, the higher the return on invested capital (ROIC), the more likely the company is to achieve sustainable long-term value creation.

• 50% ROIC ➝ A 50% ROIC means that a company provided with $1.00 in funding can reinvest those proceeds to turn the investment into $1.50.
• 25% ROIC ➝ In comparison, a 25% ROIC means that the company turned the $1.00 into $1.25 instead, so it should be straightforward to understand that a higher ROIC ratio is preferable.

Companies with higher return on invested capital (ROIC) are more likely to continue employing capital thoughtfully to achieve returns in line with the past (or similar) – albeit, identifying such opportunities early on is easier said than done.

Growth can often be the most enticing factor to investors—whether investing in the public equities or private markets— but a consistent return on invested capital (ROIC) is a more sustainable pathway to long-term value creation.

On that note, value investors in particular prioritize investing in the equity of companies led by a management team that can efficiently allocate capital toward projects that create long-term, sustainable value.

ROIC Calculator

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

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1. NOPAT Calculation Example

Suppose we’re tasked with calculating the return on invested capital (ROIC) of a company with the following financial profile as of Year 0.

• Year 0 Revenue = $200 million
• Year 0 Operating Income (EBIT) = $50 million
• Tax Rate = 30%

From Year 0 to Year 5, revenue is projected to grow $2m per year, while EBIT grows $4m per year under the same time horizon. To reflect this, we’ll use step functions as seen on the right side of the model.

The NOPAT margin – NOPAT as a percentage of revenue – expanded from 17.5% in Year 0 to 23.3% in Year 5.

Based on these assumptions, note that the growth of NOPAT is outpacing revenue, which will increase the likelihood of ROIC increasing – unless the invested capital offsets the margin expansion.

2. Invested Capital Calculation Example

Next, we’ll calculate the invested capital, which represents the net operating assets used to generate cash flow.

For the working capital schedule and fixed assets forecast, the following assumptions will be used:

• Accounts Receivable (A/R) = $80 million
• Inventories = $50 million
• Accounts Payable (A/P) = $40 million
• Other Current Liabilities = $10 million
• PP&E = $260 million

The company’s net working capital (NWC) can be calculated by subtracting the current liabilities (excluding debt and interest-bearing securities) from the current assets (excluding cash & cash equivalents).

All operating current assets are projected to decline by $2m each year while operating current liabilities are forecast to grow by $2m each year.

The PP&E balance is forecast to grow by $5m each year.

3. ROIC Calculation Example

Once the entire forecast is complete, we can calculate the ROIC in each period by dividing NOPAT by the average between the current and prior period invested capital balance.

Starting from Year 1 to Year 5, we can see an increase from 11.2% to 15.0%, which is caused by increased profit margins and the increase in operating current liabilities.

• ROIC – Year 1 = $38 million ÷ ($340 million + $337 million) = 11.2%

Since the invested capital is declining while the revenue and NOPAT are growing at a higher pace, the ROIC is rising because more value is being derived from the invested capital.

The takeaway here is that the more revenue generated per dollar of invested capital and the higher the profit margins, the higher the return on invested capital (ROIC) will be — all else being equal.

In the final step, we multiply the NOPAT margin by the average invested capital balance of the current and prior year to get the same ROICs, which confirms our calculations were done correctly.