One of the best measures of a company's ability to use capital efficiently is its return on invested capital, or ROIC. It's a measure that can also provide insights into a company's ability to generate "excess" returns, which increase the overall value of a company.
In this article, we're going to discuss the financial metric return on invested capital, or ROIC. As part of that discussion, we'll explain why ROIC is superior to some of the more traditional metrics such as return on equity (ROE) and return on investment (ROI). Next, we'll explain the four key components of the measure, and provide the formula used in its calculation. Finally, we'll offer an example that demonstrates how to use this measure.
Excess Returns
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In recent years, the financial community, as well as companies, has been focused on value creation. Companies can increase their value by creating excess returns. For example, when the return on an investment is greater than the company's cost to fund the investment, excess returns are generated. The equation below demonstrates this simple relationship:
Excess Returns = Return on Invested Capital - Cost of Capital
In the sections that follow, we're going to focus on the ROIC portion of this equation. The cost of capital is a function of the equity, debt, and preferred stock a company has issued to fund its capital needs. Our weighted average cost of capital calculator demonstrates this point.
ROIC versus ROI and ROE
ROIC tells the investor how much money is being generated by the assets the company has in place, divided by the total capital dollars used to generate those profits. It's a measure of the company's ability to invest wisely.
Return on investment tells the analyst how much money is generated by a single investment. For example, a marketer might invest $100 into an advertising campaign that returned $110 in profits. In this example, the return on the investment is $10 / $100, or 10%. ROI is frequently used in conjunction with other metrics, such as payback and net present value, to rank potential investments.
Return on equity tells the analyst the amount of net income generated for the shareholders' equity in the company. It's a measure of the profit level generated by the shareholders' money. Unfortunately, ROE doesn't tell the analyst how much debt (leverage) the company is using to generate those profits. It's often possible for a company to increase its ROE by increasing the use of debt as a source of capital, which is not a good long-term strategy.
Return on Invested Capital Equation
The mathematical formula for ROIC is more complex than ROE, ROI, or even ROA. The equation for this measure is as follows:
ROIC = Net Operating Profit after Taxes / Invested Capital
Where:
Net Operating Profit after Taxes (NOPAT) = Operating Profit x (1 - Tax Rate)
Invested Capital (IC) = Fixed Assets + Non-Cash Working Capital
Non-Cash Working Capital = Current Assets - Current Liabilities - Cash
Using NOPAT allows the analyst to calculate a profit figure that takes into consideration the company's capital structure. Since it's desirable to measure the return generated by all sources of capital (debt and equity), earnings need to consider not just income available to shareholders, but also the interest payments made to holders of debt. Another way to think about NOPAT is net income plus interest expense after taxes.
An investor working with a company's income statement can use the following calculation:
NOPAT = Net Income + Interest Expense (1-Tax Rate) - Non-Operating Income (1-Tax Rate)
Invested capital is in the denominator of the ROIC equation. This is calculated as the company's fixed assets plus current assets minus current liabilities and cash. The objective is to find out how much capital the company has in assets that are producing net operating profits after taxes.
Fixed assets are also referred to as non-current assets. Generally, they consist of plant, property and equipment as well as other "hard" assets. Non-cash working capital is also a component of invested capital. As the name implies, this is working capital less cash. Working capital is defined as current assets minus current liabilities. The three most important accounts included in working capital are accounts receivable, inventory, and accounts payable. All of the values found in the denominator of the ROIC equation can be found on the company's balance sheet.
The important fact to remember about ROIC is the measure filters out a lot of the noise that limits some of the other return calculations. The focus of this measure is the profits produced by the income-generating assets of the company.
ROIC Example
This example uses 3M Company's 2010 results. Back then, 3M had $5,956M in earnings before interest and taxes (EBIT), $201M in interest expense, and a tax rate of 40%. The company also had $15,919M in fixed assets, $12,215M in current assets, $6,089M in current liabilities, and $3,377M in cash.
Solving for the numerator:
Net Income = (EBIT - Interest Expense) x (1 - Tax Rate)
= ($5,956M - $201M) x (1 - 0.4) = $5,755M x 0.6 = $3,453M
NOPAT = Net Income + Interest Expense x (1 - Tax Rate)
= $3,453M + $201M x (1 - 0.40) = $3,453M + $201M x 0.6 = $3,574M
Solving for the denominator:
Invested Capital = Fixed Assets + Non-cash Working Capital
= $15,919M + $12,215M - $6,089M - $3,377M = $18,668M
Solving for ROIC then becomes:
ROIC = Net Operating Profit after Taxes / Invested Capital
= $3,574M / $18,668M = 19.1%
With high profit margins and a solid management team, it's no surprise that a well-run company like 3M would turn in such good results. With a return on invested capital of 19.1%, it's obvious that 3M has been investing wisely over the years. Comparing 3M's ROIC to its weighted average cost of capital (11.29% in 2010) provides a clear picture of its ability to generate excess profits.
The above calculations can be performed on our ROIC Calculator.
About the Author - Return on Invested Capital (ROIC)
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