Return on invested capital, or ROIC, is a valuable financial ratio. Understanding ROIC and using it to screen for high ROIC stocks is a good way to focus on the highest-quality businesses.
Put simply, return on invested capital (ROIC) is a financial ratio that shows a company’s ability to allocate capital.
A high return on invested capital (ROIC) means investors are realizing strong returns on their investment in a company.
The higher the ROIC, the better a company is investing it’s capital to generate future growth and shareholder value.
For example, let’s say a management team had $1 million dollars to invest, and they could either invest in a new product line, or enhancements to their existing product line. After thinking it over, the Company invests the $1 million in a new product line. One year later, the Company looks back at what they have earned on the new product line, only to find out that it’s a measly $100,000.
As it turns out, if they had invested in the enhancements to their existing product line, they would have earned $500,000 over the same period of time. What does this mean?
Well, there could be more factors at play, but based on this example, the Company’s management team made the wrong decision.
As an investor, you want your management teams making the right decisions and investing in the areas that will generate the highest returns for you as an investor.
The common formula to calculate ROIC is to divide a company’s after-tax net operating profit, by the sum of its debt and equity capital.
Once the ROIC is calculated, it is evaluated against a company’s weighted average cost of capital, commonly referred to as WACC. If a company’s WACC is not immediately available, it can be calculated by taking a weighted average of the cost of a company’s debt and equity.
Cost of debt is calculated by averaging the yield to maturity for a company’s outstanding debt. This is fairly easy to find, as a publicly-traded company must report its debt obligations.
Cost of equity is typically calculated by using the capital asset pricing model, otherwise known as CAPM.
Once the WACC is calculated, it can be compared with the ROIC.
Investors want to see a company’s ROIC exceed its WACC. This indicates the underlying business is successfully investing its capital to generate a profitable return. In this way, the company is creating economic value.
Generally, stocks generating the highest ROIC are doing the best job of allocating their investors’ capital.
By calculating a company’s return on invested capital, investors can get a better gauge of companies that do the best job investing their capital. Yet, ROIC is by no means the only metric that investors should use to buy stocks.
References:
- https://www.suredividend.com/high-roic-stocks/#top
- https://www.discoverci.com/stock-scanner/roic-screener