Return on invested capital (ROIC) measures how well a company is using its capital to make profitable investments. You calculate it by taking the net operating profit after tax (NOPAT) and dividing it by the invested capital.
ROIC helps you understand how efficiently a company is turning its capital into profits. By comparing a company’s ROIC to its weighted average cost of capital (WACC), you can see if the capital is being utilized effectively.
Calculation of Return on Invested Capital (ROIC)
The formula for ROIC is:
ROIC= ( NOPAT / Invested Capital )
where:
NOPAT = Net operating profit after taxROIC can be expressed as (net income – dividends) / (debt + equity). To figure out ROIC, you need to look at the total capital in the denominator, which combines a company’s debt and equity.
There are a few ways to calculate this total capital. One method is to take total assets and subtract cash and non-interest-bearing current liabilities (NIBCL), like tax obligations and accounts payable, as long as they don’t incur interest or fees.
Another approach is to add the book value of the company’s equity to its debt and then take away non-operating assets, which include cash, cash equivalents, marketable securities, and assets from discontinued operations.
You can also calculate invested capital by finding the working capital, which is current assets minus current liabilities. Then, subtract cash from this working capital to get non-cash working capital. Finally, add this non-cash working capital to the company’s fixed assets.
For the numerator, the simplest way to calculate it is by subtracting dividends from net income.
However, since a company might have received a one-time income boost unrelated to its main operations—like a gain from currency fluctuations—it’s often better to use net operating profit after tax (NOPAT). NOPAT is determined by adjusting the operating profit for taxes.
NOPAT = (operating profit) × (1 – effective tax rate)The Limitations
ROIC is a key valuation metric that’s super useful to calculate. But its significance varies across different sectors. For instance, companies in industries like oil drilling or semiconductor manufacturing tend to invest a lot more capital compared to those that need less heavy equipment.
One big drawback of this metric is that it doesn’t reveal which part of the business is actually creating value. If you base your calculation on net income (after dividends) instead of NOPAT, it can get even murkier, as the return might come from a one-time event that won’t happen again.
Conclusion
ROIC is a widely used financial metric that shows how effectively a company utilizes its capital and whether it’s generating value from its investments. Ideally, a company’s ROIC should exceed its cost of capital; if it doesn’t consistently do so, that could signal an unsustainable business model.
This metric is especially handy for analyzing companies that put a lot of money into their operations. Plus, like many other metrics, it really shines when you compare it among similar companies in the same industry. Typically, those firms with the highest ROICs in a sector tend to command a higher market price.