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Return on Invested Capital (ROIC)

Guide to Understanding Return on Invested Capital (ROIC)

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Return on Invested Capital (ROIC)

How to Calculate ROIC (Step-by-Step)

The term ROIC stands for “return on invested capital” and represents how well a company has put its capital to work in order to generate profitable returns on behalf of its shareholders and debt lenders.

Fundamentally, the ROIC at its core answers the following question of, “How much in returns is the company earning for each dollar invested?”

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

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

In corporate finance, some of the more common capital allocation strategies are the following:

For companies attempting to raise capital from outside investors for the first time or raise additional funding, the ROIC is a very important 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.

ROIC Formula

The formula for calculating the return on invested capital (ROIC) consists of dividing the net operating profit after tax (NOPAT) by the amount of invested capital.

Return on Invested Capital (ROIC) = NOPAT ÷ Average Invested Capital

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 the operating profits post-taxes and thus represents what is available for all equity and debt providers.

  • NOPAT → The numerator is net operating profit after tax (NOPAT), which measures the earnings of a company prior to financing costs (i.e. capital structure neutral).
  • Invested Capital → 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 term “capital” refers to debt and equity financing, which are the two common sources of funds for companies that are used to invest in cash flow generative assets and derive economic benefits.

  • 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.

NOPAT and Invested Capital Formula

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

NOPAT, or “EBIAT”, is the tax-affected operating income (EBIT) of the company, whereas invested capital is the sum of fixed assets and net working capital (NWC).

NOPAT = EBIT × (1 Tax Rate %)
Invested Capital = Fixed Assets + Net Working Capital

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

  1. Working Capital → The dollar amount of net assets that a business needs to continue operating day-to-day.
  2. Capital Expenditures → The dollar amount of 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 to calculate the invested capital is to add the net debt (i.e. subtract cash & cash equivalents from the gross debt amount) and equity values from the balance sheet.

Note that cash and cash equivalents (e.g. marketable securities) are not operating assets and thereby excluded – along the same lines, all debt and interest-bearing securities are not considered operating liabilities, either.

Cash is considered to be “sitting idle” on the B/S and is thus not part of the core operations of a company.

Return on Invested Capital Calculation Example

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

Simply put, the profits generated are compared to how much average capital was invested in the current and prior period.

If a company generated $10 million in profits and invested an average of $100 million in each of the past two years, the ROIC is equal to 10%.

  • Return on Invested Capital (ROIC) = $10m ÷ $100m = 10%

For instance, if the ROIC is 10%, that tells us the company generates $10 of net earnings with each $100 invested in the company.

How to Interpret Return on Invested Capital (ROIC)

Screening for an Economic Moat

ROIC is one method to determine whether or not a company has a defensible “economic moat“, which is the ability of a company to protect its profit margins and market share from new market entrants 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. deployment of capital).

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

Warren Buffet Moat

Warren Buffett 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 is easier said than done, but one that can yield high investment returns.

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

Hence, the 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.

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

Companies with high returns on invested capital are more likely to continue employing capital thoughtfully to achieve returns in line with the past (or similar) – it is usually very rare to come across such opportunities at the right time and share price.

Learn MoreCalculating Return on Invested Capital (Michael J. Mauboussin)

ROIC vs. WACC: General Rules of Thumb in Corporate Finance

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 or not 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 implies 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 this will be firm-specific and depend on the type of strategy employed.

Learn More → ROIC by Sector (Damodaran)

Full Form ROIC Formula: Value Driver 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 in 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, is the following equation.

ROIC = (Revenue ÷ Average Invested Capital) × (NOPAT ÷ Revenue)

NWC affects the 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 can be considered an indication that a company is required to spend less to generate more profit.

  • Profitable Returns 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 Improve ROIC: Firm Value Creation Methods

Namely, there are five predominant methods for corporations to create positive economic value over the long run:

  1. Invest in High Return, Profitable Projects – i.e. ROIC > WACC (“Value Creating”)
  2. Capital Efficiency – e.g. Higher Asset Turnover, Higher Inventory Turnover, Revenue Maximization
  3. Operating Improvements – i.e. Higher Profit Margins, Reduce Unnecessary Spending
  4. Optimize Capital Structure — i.e. Potentially Lower WACC from Issuance of Debt
  5. End “Value Destroying” Projects

Importance of Understanding Growth and ROIC Ratio

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 destroyed value as opposed to creating shareholder value.

In Scenario A, the change in invested capital was $25m more for an increase of $5m in NOPAT.

In contrast, in Scenario B, the NOPAT increased by $5m too, but $150m was spent, so focusing on the growth in NOPAT by itself would be misleading in the latter case.

ROIC Calculation Exercise

ROIC Calculator – Excel Model Template

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

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Step 1. NOPAT Calculation Analysis

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, as shown below. To reflect this, we’ll use step functions as seen on the right side of the model.

The NOPAT margin (% of revenue) expands from 17.5% in Year 0 to 23.3% in Year 5.

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

Step 2. Invested Capital Calculation Analysis

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:

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, whereas the operating current liabilities are forecasted to grow by $2m each year. And the PP&E balance will grow by $5m each year.

Step 3. ROIC Calculation Example

Once the entire forecast has been filled, 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 the increased profit margins and the increase in operating current liabilities.

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 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.

ROIC Calculator

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Yao Shan
Yao Shan
August 23, 2022 9:46 pm

Hi Brad, Are the goodwill and deferred tax asset / liability counted as operating assets / operating liability? Are they inclusive in invested capital? I believe operating asset and invested capital (NWC and fixed asset) are two distinct concepts, operating asset is a more broader concept, there are assets that… Read more »

Last edited 3 months ago by Yao Shan
Phryne
Phryne
August 8, 2022 1:36 pm

Do operating leases count as fixed assets?

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