In the strictest sense, return on invested capital (ROIC) is a measure of the percentage of return a company derives from its capital investments. As a tool, this metric can be used to get a sense of the value of a company. After all, a company’s ROIC is an indication of how effectively its management team is putting its dollars to work.
Or, said differently, it’s an indication of how well a company is using its capital to produce profits. Basically, calculating a company’s ROIC answers the question: “How much is this company making on each invested dollar?”
Generally, a company is perceived to be creating value when its ROIC exceeds 2% and losing value when its ROIC is less than 2%. For example, as of June 2022, Netflix’s (NASDAQ: NFLX) ROIC was 12.97% and Starbucks’ (NASDAQ: SBUX) was 14.74%. Meanwhile, once highflying companies like Eastman Kodak’s (NYSE: KODK) stood at .24%, while Xerox’s (NASDAQ: XRX) was .19%.
Here, one can see how ROIC can be revealing when it comes to comparing the relative profitability of a variety of companies. Some analysts consider ROIC to be the preferred benchmark when it comes to comparing the performance of competitors.
Moreover, if forced to rely upon a single metric to determine the viability of an investment in a company, many people consider ROIC to be a potentially good one to consider (though we hasten to add that investors should never rely upon ROIC alone to make an investment decision).
Among terms investors may encounter when considering return on invested capital are return on capital employed (ROCE), earnings before interest and tax (EBIT), and net operating profit after tax (NOPAT).
ROCE – ROCE differs from ROIC in that it measures the profits earned on capital that was employed. Essentially, where ROIC is net operating income divided by invested capital, ROCE is net operating income divided by the capital employed.
In other words, ROCE takes into consideration the total amount of capital employed, including debt and equity financing, less short-term liabilities.
Meanwhile, ROIC looks only at the capital actively circulating within the business. In situations in which a company’s ROCE is greater than the cost of capital, it is said to be using its capital effectively. With ROIC, as long as the value is greater than zero, the company is considered to be profitable.
Another key difference is the fact that ROCE is based on pre-tax returns, while ROIC is based on post tax numbers. As a result, ROIC is a better indicator of what investors can expect in the form of dividends. On the other hand, ROCE makes it easier to compare the results of two competing companies operating under differing tax systems.
EBIT – Sometimes referred to as operating income, earnings before interest and taxes, when divided by sales revenue, can reveal a company’s operating margin. This can then be compared to past margins, as well as those of similar companies, to gauge a company’s performance. This makes EBIT useful for calculating ROIC because it is a measure of the profit a company generates before creditors are paid.
EBIT also eliminates taxes in the calculation of ROIC, which makes it easier to compare two companies who may have different tax issues. As an example, in an instance in which two companies are selling the same product with the same profit margin, the company selling into a lower tax environment will appear to have a better ROIC. The reality, though, is that both companies are equally profitable. The difference is that one has a higher tax burden than the other. This makes EBIT a more useful metric when using net income.
NOPAT – Net operating profit after tax excludes the cost and tax benefits of debt financing. While similar to EBIT, NOPAT adjusts EBIT to take the impact of a given tax structure into consideration. In other words, NOPAT can more vividly illustrate operational efficiencies because it excludes debt and interest payments.
The formula for calculating NOPAT is: [Net Income + Tax + Interest Expense + any Non-Operating Gains/Losses x (1 – tax rate)
Because interest payments are a pre-tax expense, NOPAT subtracts from a company’s earnings before taxes. While this can appear to reduce the overall net profit, it also reduces tax liability. This enables NOPAT to provide a better assessment of how a company operates than one could discern by considering net income alone.
ROIC is calculated by dividing the net operating cost by the amount of invested capital. Meanwhile, as stated above, NOPAT is calculated by multiplying EBIT by 1 minus the tax rate.
Generally, the book value of a company is better to use for this calculation than market value. After all, the ROIC based on market value can be misleading. Why? Market value takes future expectations into consideration, whereas book value looks only at the present situation.
Thus ROIC = NOPAT/Sales x Sales/Invested Capital.
Sales cancel themselves out in this equation, leaving NOPAT/Invested Capital.
Thus, if a company generates $20m in NOPAT and has $200m in invested capital, its ROIC is 10%.
For investors, the long-term value of a company is critical — particularly for growth-oriented investors who are pursuing a distant time horizon. While current earnings and cash flow do matter, the ability of a company to use its capital to build value has more significance in this regard.
Generally, companies with a high ROIC have greater potential to sustainably create long-term value, because their management teams are more likely to thoughtfully employ capital. As a result, a company with a high ROIC also tends to trade at a higher price-to-book ratio.
An oft-employed implementation of ROIC in investment decisions involves comparing a company’s ROIC to its weighted average cost of capital (WACC). This is the after-tax cost of capital regardless of its source. This can include sales of common stock, preferred stock, bonds and any other form of debt the company engages.
Comparing a company’s ROIC to its WACC can demonstrate its ability (or inability) to create enough value to make it a worthwhile investment. Ultimately, the WACC dictates a company’s required rate of return to finance its assets. A stock that has exhibited a high degree of volatility, or one that is perceived to have risky debt, will have an elevated WACC and thus represent a more significant degree of risk.
On the subject of risk, varying the mix of asset classes held within a portfolio can potentially help mitigate it. Fixed-price assets such as bonds, certificates of deposit and treasury notes usually respond to market volatility more favorably than publicly traded equities.
Alternative investments can also be potentially useful tools for portfolio diversification, which is generally agreed upon by experts to be a smart investment strategy to pursue. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.
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Ultimately, considering a company’s return on investment capital can be a useful metric by which to get a sense of the viability of an investment in a company. However, it is important to remember that ROIC only looks at one aspect of a company. It is also important to compare the ROIC to the weighted average cost of capital to get a sense of an asset’s future growth potential.
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