How to Calculate Return on Invested Capital   (ROIC) – Why use NOPAT?

Return on invested capital (ROIC) is usually calculated with Net Operating Profit After Taxes (NOPAT  ) instead of just corporate profits more commonly measured as Net Income (NI).  What about NOPAT makes it a superior indicator of corporate profitability   vs. net income?

NOPAT Definition

NOPAT (Net Operating Profit After Taxes) is the profit that a company realizes from ongoing profit generating operations of the company.  For example, a stereo store will count earnings from selling stereos using NOPAT, but will not count income from leasing out extra space in it’s stereo store building as an office to another business, as that is not a part of it’s primary business activity.  This is different than net income, which counts all income a company generates, even if it is not generated from it’s primary business activity.

How to calculate NOPAT

Here is how to calculate NOPAT:

Net Sales – Operating Expenses = Operating Profit (Also known as EBIT or Profit from Operations)
EBIT – Taxes = NOPAT

A good thing about NOPAT is that it starts with net sales instead of net income, which eliminates income and expenses that are not associated with the main profit making operations of a company.  This eliminates items like interest expense and interest income. 

By focusing on profits (earnings) that are generated from the ongoing operations of a company, instead of the overall net income of a company, which contains GAAP related items that create financial noise, a clearer picture will emerge to help you find companies that are growing and may make good investments.

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Equity Growth Rate

Equity growth rate for any company is also known as the book value growth rate.  Equity is what is left over when liabilities are subtracted from assets on a company’s balance sheet.  Equity represents what is left over if a company is liquidated and ceases to exist.  The equity growth rate is the percentage that equity   per outstanding share of stock (or book value per share) has grown over the last year.  Equity grows when a business accumulates surplus profits.  Think about it – many profitable businesses have to use their earnings to fund their growth, either by building new stores, replacing old or worn out capital equipment, etc.  Businesses that accumulate excess profits while still growing are special indeed!  We use equity growth rate to find these great businesses.

How to Calculate Equity Growth Rate

Learning how to calculate equity growth rate is a great companion for the other skill you learned for finding great investments when you learned how to calculate ROIC  .  Equity growth rate is calculated by dividing this years book value per share by last years book value per share, the subtracting 1:

Equity Growth Rate = BVPS(today)/BVPS(last year) – 1

Equity growth rate is represented as a percentage.  Make sure you adjust for dividend distributions (if any) to get an accurate view of equity growth rate.

What to look for in equity growth rate

Consistent equity growth of greater than 10% over 5 to 10 years is what a great company should have.  If you see some anomallies in the historical equity growth rates, take the time to understand why those divergences from the trend occurred (both up or down divergences).  Value investing looks for companies with good equity growth rates that may be temporarily under priced.  Comparing the equity growth rate between companies in the same industry is a good way to rate which ones should be considered as an investment.

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