Return on invested capital (ROIC) reflects the return on total cash invested in the business, by way of equity and/or interest-bearing debt. It recognizes that a large portion of total assets is funded by non-interest bearing liabilities from trade creditors, deferred taxes, advance payments by customers (deferred revenue), etc. That free funding essentially reduces the capital investment required and boosts returns.
Return on invested capital (ROIC) is calculated as:
Net Operating Profit After Tax (NOPAT) / Invested Capital
see APPENDIX 1 for more details.
Why use ROIC?
ROIC focuses on efficient capital management and sustainable growth.
Return on Equity (ROE) also reflects capital management but can be distorted by increased use of debt, especially where the company takes on debt to fund stock buybacks (which reduce shareholders equity). If debt is rising, ROE may not reflect a sustainable growth rate.
ROA is an objective measure of performance but does not reflect effective working capital management, where trade liabilities are used to fund a large portion of operating assets.
How to use ROIC
Levels above 10% are good and would usually exceed the company’s weighted cost of capital by a healthy margin. Above 15% is even better and normally reflects that the company has a sustainable advantage over its competitors and is able to defend its market share while earning healthy profit margins (i.e. without cutting prices).
ROIC is not always constant. Where it fluctuates from year-to-year, extract a long-term average and compare that to future projections.
ROIC growing at a steady rate normally indicates that the company is strengthening its advantage over competitors — by developing hidden assets such as brands, patents, scientific know-how, trade secrets, economies of scale, prime locations (for retailers or building materials suppliers), licenses or exploration rights, that are not reflected on the balance sheet — which should enhance future growth.
ROIC declining at a steady rate normally indicates that the company is losing its competitive advantage.
Strengths
ROIC:
- Provides a useful yardstick of management efficiency in their allocation of invested capital (IC).
- Avoids the distortion caused by varying debt levels.
- Avoids the distortion to sales and earnings caused by growth through acquisition.
- Mitigates the distortion of stock buybacks where funded by debt.
- Enables comparison of performance between companies with similar assets but different debt structures.
- Is also used to calculate the sustainable growth rate that the company should be able to achieve over the long-term, without raising additional debt or equity. For example, if a company achieves ROIC of 10% and does not distribute funds to shareholders — via earnings or stock buybacks — earnings are likely to grow at a compound rate of 10% p.a. and no more.
Weaknesses
- Historic cost of assets may understate or overstate their current value in invested capital (IC).
- NOPAT does not equal cash flow:
- especially where capital expenditure and acquisitions are higher than depreciation plus amortization (D&A); or
- working capital increases in line with sales growth.
A counter to the first weaknesses is that ROIC is based on accounting definitions, so that overstatement of an asset (in the IC denominator) will result in an at least partially offsetting overstatement of D&A expenses in the numerator. And vice versa.
Similarly, where NOPAT is overstated relative to free cash flow (FCF), the IC denominator is also likely to be overstated. Likewise, if working capital increases are not deducted from NOPAT, overstating NOPAT relative to FCF, they are partially offset by inclusion in the IC denominator.
Examples
Company A has no Debt and earns NOPAT of 1,000 based on invested capital of 10,000.
ROIC is 10% (1,000/10,000) and NOPAT and earnings per share (EPS) are likely to grow at a compound growth rate of 10%.
Company B is the same as A except that it has 5,000 in Debt and only 5,000 in Shareholders Equity.
ROIC is the same 10% (1,000/10,000) and NOPAT is likely to grow at a compound growth rate of 10% but earnings per share (EPS) may grow at a faster rate (ROE) because of the increased leverage — and increased risk.
Company C is the same as A except that it makes a 5,000 acquisition at the start of the year, funded by Debt, with NOPAT of 400.
ROIC falls to 9.3% (1,400/15,000), reflecting the inefficient use of capital, and NOPAT is likely to grow at the same rate. Earnings per share (EPS) may grow at a faster rate (ROE) because of the increased leverage — and increased risk.
Company D is the same as A except that it invests 5,000 at the start of the year in new, more efficient plant and equipment that generates NOPAT of 600, funded by a stock issue.
ROIC rises to 10.7% (1,600/15,000) because of the increased capital efficiency and NOPAT is likely to grow at the same rate. Earnings per share (EPS) will also grow at the same rate as ROIC because there is no leverage using Debt.
Company E is the same as A but reduces its working capital (and IC) by 1,000, negotiating more favorable payment terms with creditors. The proceeds are returned to shareholders via a 1,000 special dividend or stock buyback.
ROIC rises to 11.1% (1,000/9,000), reflecting the more efficient use of capital, and NOPAT and earnings per share (EPS) are likely to grow at the same compound growth rate of 11.1%.
| Company | NOPAT | Invested Capital | Debt | Equity | ROIC | Calculation |
|---|---|---|---|---|---|---|
| A | 1,000 | 10,000 | nil | 10,000 | 10% | 1,000/10,000 |
| B | 1,000 | 10,000 | 5,000 | 5,000 | 10% | 1,000/10,000 |
| C | 1,400 | 15,000 | 5,000 | 10,000 | 9.3% | 1,400/15,000 |
| D | 1,600 | 15,000 | nil | 15,000 | 10.7% | 1,600/15,000 |
| E | 1,000 | 9,000 | nil | 9,000 | 11.1% | 1,000/9,000 |
APPENDIX 1: How is ROIC calculated?
Return on invested capital (ROIC) is calculated as:
Net Operating Profit After Tax (NOPAT) / Invested Capital
Where:
- NOPAT can also be calculated as Net Income + Interest * (1-tax rate)
- Invested capital (IC) is Total Assets – Non-Interest Liabilities
- IC is also equal to Shareholders Equity + Debt
Improvements
- Use averages rather than the year-end balance if there has been significant change over the year (e.g. average Total Assets, Non-interest Liabilities, Equity and/or Debt).
- Exclude Excess Cash where there is a large cash surplus on the balance sheet.
- Exclude Non-Operating Assets such as equity investments.
ROIC is intended to reflect return on operating assets.
How is ROIC different from ROA and ROE?
Return on Assets (ROA) is calculated as: NOPAT / Total Assets
Return on Equity (ROE) is calculated: Net Income / Shareholders Equity
They measure returns on three different levels of investment:
ROA >> Total assets
ROIC >> Net operating assets (Total assets – Non-Interest liabilities)
ROE >> Shareholders equity (Total assets – Non-Interest Liabilities – Debt)