Return On Invested Capital (ROIC) – Definition, Formula & Interpretation

The invested capital is the total funds generated by the company by issuing equity and debt in the market. People who subscribe to equity are called shareholders, and the latter are bondholders or borrowers (like banks). The sum of funds raised through and bond is called invested capital. The return generated by the business on its invested capital is called Return on Capital Invested (ROIC).

The formula of ROIC will look like this:

In this article, we will dig deeper into the ROIC formula. We will study all three components of the formula. First, we will study the numerator (return). We will know what numbers to pick from the P&L account to quantify the return. 

Second, we will understand what numbers of the balance sheet are to be picked to quantify the invested capital. Finally, we will see how to interpret the ROIC number. 

Before proceeding, I would like to mention here that the ROIC formula indicated here may sound different from the formulas indicated in other web portals. The reason for this difference is that this article is derived from one of the papers written by Mr. Aswath Damodaran of Stern School of Business. 

So let’s start with our first metric, the return. 

The Return

The total capital generated by the company is invested to buy assets. These assets in turn generated returns. The returns so generated are measured against the total capital invested, called ROIC. 

In ROIC calculations, the return will be after-tax operating income and not net profit (PAT). 

Why PAT is not considered in ROIC calculations? Because PAT is the earnings available only to the shareholders and not to the borrowers (like banks). Why? Because the borrower’s return is the interest paid out to them. The interest is not paid from net income, it will come from operating income. An even better indicator of the return available at the hands of shareholders and borrowers is after-tax operating income. 

The formula for after-tax operating income will be:

Quick notes on the components of the after-tax operating income:

• Operating Income: It is derived from the net profit (PAT) of the company. Subtracting non-operating income from PAT gives us the operating income. Non-operating income is often indicated as “Other Income” in the profit and loss statement. The operating income is a measure of the profit-generating potential of the company’s operations. 
• Interest Expenses: The interest expense is added to operating income. This action quantifies the total profit available to both shareholders and borrowers. 
• (1-Tax Rate): Interest paid on loans acquired by the company helps to save tax. So if there will be no loan, this tax saving will also fade away. Hence to factor in the effect of loans on the total income, the component of “1-TaxRate” is added to the formula as shown above.

The Invested Capital

Before we’ll discuss the invested capital, I’ll like to highlight the source and application of funds. The source of funds is from two avenues, equity, and debt. The funds so sourced are applied to purchase fixed assets like property, plant, and equipment. The fund is also used to fund the working capital requirements. Some part of the money is also kept as cash. Some companies also use cash to buy intangible assets like brand names, patents, copyrights, etc. 

In the calculation of Return on Invested Capital (ROIC), the invested capital is chosen prudently. The total capital is not considered as invested capital, but only a part of it. Check the below formula for the invested capital:

Quick notes on the components of the after-tax operating income:

• Fixed Assets: All funds diverted to build or purchase assets for the company is invested capital. Such assets can be PP&E (property, plant, and equipment). 
• Working Capital: Current assets are the source of funds for a company in a short term. Current liabilities are financial obligations that must be paid in short term (< 1 year). The current assets available with the company after taking care of all current liabilities are called working capital. It is used by companies to pay their forthcoming bills (salary, vendor bills, utility bills, interest payments, taxes, etc). Working capital can be treated as invested capital. 
• Non-Cash Working Capital: Cash is not treated as invested capital. Why? Because the cash kept in the bank account earns little or no income. In the numerator, we do not consider interest income as a component of return. Similarly, we will not include cash balance as a component of invested capital. Working capital minus cash is called non-cash working capital, it is invested capital.

How to Interpret ROIC?

ROIC number on its own depicts how much return is generated for every Rs.100 of invested capital. The higher is the ROIC number the better.

But it is not fair to compare two businesses operating in different sectors/industries. Generally, capital-intensive businesses will display lower ROIC than others.

A better way to analyze ROIC is by comparing it with a company’s WACC (weighted average cost of capital). If ROIC is higher than the cost of capital, the company is said to be adding value for its investors (shareholders and borrowers). 

Generally speaking, if the ROIC is 2% to 3% higher than WACC, it is ideal. 

Conclusion

ROIC highlights the return generated by the first for its investors, shareholders, and borrowers. Which ROIC number is good? ROIC greater than its WACC is a must. For companies whose ROIC is less than WACC, they are value destroyers. As an investor, we can stay away from such companies. 

How do I use ROIC? Whenever a low PE stock attracts my attention, I look at its ROIC. Why? Because it tells me if the company is really undervalued or there is a reason why people are not buying or selling this stock. A low PE and high ROIC (higher than its WACC) is what I like to see in a company. 

Similarly, a high PE stock displaying a high ROIC deserves to trade at a premium price. In the future, such stocks may grow even higher. 

I hope you liked this write-up on ROIC. 

Please keep reading and have a happy investing.