Return on Invested Capital (ROIC) is a performance ratio that aims to measure the percentage return that a company earns on invested capital.

The Return on Invested Capital (ROIC) ratio shows how efficiently a company is using the investors’ funds to generate net income. Investors use the ROIC ratio to compute and to understand the value of a company. It represents for investors how well a company has put its capital to work in order to generate profitable returns on behalf of its shareholders and debt lenders.

Fundamentally, ROIC answers the question:

• “How much in returns is the company earning for each dollar invested?”

Return on Invested Capital is calculated by taking into account the cost of the investment and the returns generated.

• Returns are all the earnings acquired after taxes but before interest is paid.
• The value of an investment is calculated by subtracting all current long-term liabilities, those due within the year, from the company’s assets.

The cost of investment can either be the total amount of assets a company requires to run its business or the amount of financing from creditors or shareholders. The return is then divided by the cost of investment.

Net operating profit after tax (NOPAT) is typically used in the numerator because it captures the recurring core operating profits and is an unlevered measure (i.e. unaffected by the capital structure).

Unlike net income, NOPAT is the operating profits post-taxes and thus represents what is available for all equity and debt providers.

• Return on Invested Capital (ROIC): The numerator is net operating profit after tax (NOPAT), which measures the earnings of a company prior to financing costs.
• Invested Capital: As for the denominator, the invested capital represents the sources of funding raised to grow the company and run the day-to-day operations.

Capital refers to debt and equity financing, which are the two common sources of funds for companies that are used to invest in cash flow generative assets and derive economic benefits.

A company can evaluate its growth by looking at its return on invested capital ratio. Any firm earning excess returns on investments totaling more than the cost of acquiring the capital is a value creator. Excess returns may be reinvested, thus securing future growth for the company. An investment whose returns are equal to or less than the cost of capital is a value destroyer. Generally speaking,

• A company is considered to be a value creator if its ROIC is at least two percent more than the cost of capital;

• A company is considered to be a value destroyer is if its ROIC is two percent less than its cost of capital.

There are some companies that run at zero returns, whose return percentage on the value of capital lies within the set estimation error, which in this case is 2%.

A higher return on invested capital can be considered an indication that a company is required to spend less to generate more profit.

• Profitable Returns on Invested Capital (ROIC) → Positive Value Creation and Shareholder Returns

The higher the profit margins of the company, the higher the return on invested capital, as the company can convert more revenue (or NOPAT) into profits.

Companies that generate an ROIC above their cost of capital implies the management team can allocate capital efficiently and invest in profitable projects, which is a competitive advantage in itself.

When investors screen for potential investments, the minimum ROIC tends to be set between 10% and 15%, but this will be firm-specific and depend on the type of strategy employed.

ROIC is one method to determine whether or not a company has a defensible “economic moat”, which is the ability of a company to protect its profit margins and market share from new market entrants over the long run.

Warren Buffett

The overall objective of calculating ROIC is to better understand how efficiently a company has been utilizing its operating capital (i.e. deployment of capital).

Generally, the higher the return on invested capital (ROIC), the more likely the company is to achieve sustainable long-term value creation.

References:

1. https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-roic/
2. https://www.wallstreetprep.com/knowledge/roic-return-on-invested-capital/