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 Invested Capital (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 on 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 the Stern School of Business. 

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

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• Point #1. The ROIC Formula

• Point #2. The Invested Capital Formula

• Point #3. How to Interpret ROIC?

• Point #4. Limitations of ROIC

• Point #5. Comparison Between ROIC, ROCE, and ROA

• Point #6. How Do Investors and Analysts Use ROIC?

• Conclusion

• FAQs

The ROIC Formula

Let’s explore the ROIC meaning.

The total capital generated by the company is invested to buy assets. These assets in turn generated returns. The returns 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). 

ROIC = After Tax Operating Profit (NOPAT) / Invested Capital

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 (NOPAT) will be:

NOPAT = (PAT – Other Income) + Interest * (1-Effective Tax Rate)

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 is 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.

ROIC is a critical component of the valuation process. It tells you how efficiently a company is generating cash flows from its invested capital. A company’s future growth prospects should be assessed in conjunction with its historical ROIC

– Anonymous

The Invested Capital Formula

Before we discuss the invested capital, I’d 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. 

How to calculate invested capital? 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), the invested capital equation:

Invested Capital = Fixed Assets + (Current Assets – Current Liabilities) – Cash

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

• Fixed Assets: All funds diverted to build or purchase assets for the company are 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 the short term. Current liabilities are financial obligations that must be paid in the 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 the ROIC number the better.

However, 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. 

Limitations of ROIC

Return on Invested Capital (ROIC) is a valuable metric for assessing a company’s profitability and capital efficiency. However, it does have limitations when used in isolation. One key limitation lies in its disregard for short-term dynamics and fluctuations.

ROIC provides a snapshot of a company’s performance at a specific point in time, making it less sensitive to short-term changes. For instance, a company that makes significant capital investments in one year may experience a lower ROIC during that period due to the temporary increase in capital employed. Though those investments are expected to yield long-term benefits, ROIC does not consider future possibilities.

ROIC may not also account for variations in industry norms and cost structures, making it challenging to compare companies from different sectors.

Comparison Between ROIC, ROCE, and ROA

Here’s a comparative analysis between ROIC, ROCE, and ROA:

When to Use Each Metric and Insights Provided:

1. ROIC (Return on Invested Capital): Use ROIC when you want a comprehensive view of a company’s capital efficiency and profitability over the long term. It is valuable for assessing both equity and debt returns, making it suitable for long-term investors. ROIC is sensitive to changes in debt levels, making it insightful for evaluating leverage’s impact on returns.
2. ROCE (Return on Capital Employed): Employ ROCE when you want to assess capital efficiency and profitability while considering long-term debt, but you have a specific focus on equity returns. ROCE is suitable for companies with varying levels of debt and provides insights into the efficiency of capital utilization. It’s valuable for industry comparisons but still requires consideration of industry norms.
3. ROA (Return on Assets): Choose ROA when you want to evaluate how efficiently a company uses its assets to generate profits in the short to medium term. ROA is less influenced by capital structure differences and is appropriate for analyzing asset efficiency. It’s relevant for assessing operational efficiency and profitability, especially for shorter-term investment horizons.

ROIC is the true measure of corporate performance, as it considers both profitability and capital efficiency. Investors should focus on the long-term sustainability of a company’s ROIC to make informed investment decisions.

– Anonymous

How Do Investors and Analysts Use ROIC?

Investors and analysts use Return on Invested Capital (ROIC) as a key metric in their decision-making processes. ROIC provides valuable insights into a company’s financial performance. It can have a significant impact on stock valuations and investment strategies.

Here’s how investors and analysts use ROIC:

1. Profitability and Efficiency: ROIC is a measure of how efficiently a company generates returns on the capital it has invested in its operations. It is used to gauge the company’s profitability and efficiency in utilizing its resources. A high ROIC suggests that the company is effective at generating profits from its invested capital. A low ROIC points towards operational inefficiency.
2. Comparing Companies: ROIC can used to compare companies within the same industry. It highlights which companies are making the best use of their capital. By comparing ROIC across competitors, investors can identify potential good stocks.
3. Valuing Stocks: ROIC can influence stock valuations. Companies with consistently high ROIC are often considered more valuable. They are seen as capable of generating strong returns for shareholders and creditors. Stocks of companies with high ROIC tend to trade at higher P/E multiples.
4. Risk Assessment: Analysts assess the risk associated with a company’s capital structure by considering both the level of debt and the ROIC. Companies with high ROIC and manageable debt levels are generally viewed as less risky.
5. Long-Term Suitability: A company that consistently generates a high ROIC is seen as a good candidate for long-term investment.
6. Capital Allocation Decisions: Companies with high ROIC have the flexibility to reinvest profits in growth initiatives, pay dividends to shareholders, or reduce debt.

ROIC is a key metric in my investment toolkit. It’s not just about buying good companies; it’s about buying good companies at reasonable prices. ROIC helps me identify companies that can compound wealth over time.

– Anonymous

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. Companies whose ROIC is less than WACC, 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 if there is a reason why people are not buying or selling this stock. A low PE and high ROIC (higher than its WACC) are 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. 

ROIC is like the heartbeat of a business. It shows you how well a company is performing operationally. A high ROIC suggests a company has a competitive advantage and can create value for shareholders.

– Anonymous

FAQs

I hope you liked this write-up on ROIC. 

Have a happy investing.