Return On Invested Capital (ROIC): What It Is & How To Calculate
Return on invested capital is a financial metric that investors use to analyze the profitability of a company's existing investments and expansion opportunities.
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What Is ROIC?
Analysts use the return on invested capital (ROIC) metric to evaluate a company's capital allocation decisions. In particular, it's common to use ROIC in comparison with a company's weighted average cost of capital (WACC).
In general, if a company has an ROIC higher than its WACC, it has a strong economic moat and is generating a positive return on its investments. On the contrary, it's a poor indicator if it costs a company more to access funding than it is earning on new investments. In such a case, it would be better for shareholders if the company limited growth.
ROIC is useful both as a standalone metric and to compare companies within the same industry. If one firm consistently earns higher returns than its peers, it will likely be able to capture market share over time.
Return on Invested Capital Formula
To calculate return on invested capital, divided net operating profit after tax by invested capital.
ROIC Formula (Author's own work)
If a firm had a net operating profit after tax (NOPAT) of $10 million and $100 million of invested capital, it would be generating an ROIC of 10%. Simple enough.
However, here, some complications can emerge. Different analysts use a variety of definitions or adjustments to certain elements of the above formula. For clarity's sake, here's are the steps to calculating both inputs to arrive at ROIC, as it is most commonly understood.
Calculating Net Operating Profit After Taxes (NOPAT)
Generally, NOPAT of a business is calculated as follows:
NOPAT = Net Income + Tax + Interest Expense + Non-Operating Gains and/or Losses x (1 - Its Tax Rate)
By adding back in interest expense, NOPAT neutralizes the effect of leverage. When comparing a business with a lot of debt to one with a net cash position, interest greatly distorts apparent profitability. NOPAT gives investors a sense of a business' true underlying profitability without worrying about its interest expense.
That, in turn, plugs into the ROIC formula, helping investors to appreciate a firm's core efficiency in using its assets. However, it's important to get the invested capital piece right as well.
Invested Capital Formula
There are multiple ways to calculate invested capital. A simple one that gets the job done is the following formula:
Invested Capital = (Total Debt + Total Shareholders' Equity) - Non-Operating Assets
Shareholders' equity is the money that investors have supplied to the company to run its operations. It's usually listed as total shareholders equity in a company's regulatory filings. For total debt, analysts often use the company's current debt plus its long-term debt obligations and its outstanding capital lease or rent obligations.
Finally, non-operating assets are removed from the invested capital figure. This is most commonly cash and marketable securities, which will be listed in the current assets portion of the balance sheet. This adjustment makes sense because ROIC is focused on the return a company earns on its active investments. Inert cash sitting in a corporate bank account shouldn't be included in measuring capital allocation efficiency.
ROIC Calculation to Determine Company Value
Companies with high ROICs tend to earn premium valuation multiples from investors. A company with an above-average ROIC will often also sport a high price-to-earnings and price-to-sales multiple.
What constitutes a high ROIC depends greatly on the industry. A firm with a very many plants and much equipment, such as a steel producer or automaker, is likely to have a fairly low ROIC. By contrast, most software firms have higher ROICs.
As such, it's generally more useful to compare how firms operate compared to their peers within an industry as opposed to companies in completely different industries.
Shortfalls Of ROIC
ROIC is a useful metric, but its utility diminishes in some cases. For example, companies with multiple types of business under one roof may end up with a distorted ROIC as opposed to its true reinvestment opportunities.
Consider a holding company like Berkshire Hathaway. It will earn a very different ROIC reinvesting in a capital-heavy business such as its railroad or its renewable energy division as opposed to its chocolate or insurance businesses. An investor should consider the profitability of each major Berkshire subsidiary compared to rivals in its own industry rather than just using overall ROIC in isolation.
Some industries, like insurance and banking, don't take well to ROIC analysis. Invested capital is a tough metric to square with financial industry businesses where capital itself is a major piece of the end product. ROIC is much more useful in industries where companies spedn heavily on offices, warehouses, land, manufacturing facilities, equipment and so on.
Return on Invested Capital Example
Suppose that a manufacturing company has a weighted average cost of capital (WACC) of 8%. This means that, on average, it will need to earn more than 8% on new investments to generate positive shareholder value.
If the company announces a new $100 million project that will generate $10 million per year in profits, that should be a benefit to shareholders. After all, its cost of capital would be $8 million and its return $10 million, resulting in $2 million of value creation. However, in cases where a ROIC and WACC are close to each other, be careful, as there is less margin of safety.
Particularly in a rising interest rate environment, a company's WACC can surge higher, making formerly profitable lines of business uneconomic. On the other hand, if a company's ROIC is far above its WACC, it should aggressively invest in further expansion opportunities.
Tip: If a company's ROIC is well in excess of its WACC, it has a good chance of generating strong shareholder returns when it expands its business.
Is a High ROIC Always Attractive?
In general, a higher ROIC is better. However, there are exceptions. One classic example is in a mature industry where there are few opportunities for growth. The market leader is likely to display a higher ROIC figure but has fewer opportunities to actually deploy more capital into its business.
Once a company has finished reaching its total addressable market, it may pursue adjacent industries with a lower ROIC. However, if these investments still yield a higher return on investment than alternatives such as buying back stock or paying down debt, it may be a prudent use of shareholder funds even though it optically lowers the company's ROIC metric.
ROIC vs. ROE vs. ROI
Return on invested capital (ROIC) is a key metric because it shows a company's reinvestment runway. An investor can quickly deduce what sorts of returns, on average, a company can expect to receive on its new investments.
Return on equity (ROE), by contrast, uses net income and compares that to a firm's equity. ROE is a useful high-level metric to give a sense of how efficient a company is in managing its entire operation. However, with ROIC, an investor can zoom in on the capital that is being allocated into the business. Also, ROE can be distorted if a company uses a ton of debt; many high ROE firms get there through a lot of leverage rather than superior business models.
Return on investment (ROI), at a glance, may seem quite similar to ROIC. However, it tends to be a metric used for evaluating one particular project. If a company expands this factory or builds that mine, what return will it earn on that decision? ROIC, by contrast, gives a blended measure of all of a company's investment decisions.
Important: A key difference between ROIC and ROE is that ROIC filters out debt from the equation, while ROE gives companies credit for leveraging their balance sheets.
Bottom Line
Return on invested capital is a great metric for assessing the effectiveness of a company's capital allocation program.
It stands out from many other common financial metrics because it considers the whole balance sheet. Many other ratios involve net income.
However, accounting earnings sometimes don't give the full picture of a company's true results. ROIC can give investors a more comprehensive view of the real long-term economics of a firm's business model.
This article was written by
Ian worked for Kerrisdale, a New York activist hedge fund, for three years, before moving to Latin America to pursue entrepreneurial opportunities there. His Ian's Insider Corner service provides live chat, model portfolios, full access and updates to his "IMF" portfolio, along with a weekly newsletter which expands on these topics.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of BRK.B either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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