ROIC – What is Return On Invested Capital?

What is return on invested capital?   

Most casual investors have probably never heard of the acronym ROIC.  Investors that do their homework before they buy a stock have probably run across ROIC, but don’t really understand what it is, or why it is important.  So, what is return on invested capital?  At a high level, ROIC is a way to measure how efficiently it uses the cash it invests in it’s operations – whether that cash comes from loans or cash it generates from its ongoing operations.  Another way looking at ROIC is the amount of profit that a business generates for every dollar invested in it’s ongoing operations.

Before we get into too much detail, here is how to calculate ROIC (return on invested capital):

Net Operating Profit After Tax
——————————————————
Invested Capital (Long Term Debt + Equity)

When trying to answer the question “what is return on invested capital?”, or “why is ROIC better than ROE?”, there are a couple of details that an investor must master.  First, unlike return on equity, return on invested capital looks at all funding sources that a company’s management team uses to fund the growth of the business.  This includes both equity investments from shareholders, as well as debt investments from bondholders and banks.  ROE only uses shareholder equity as the denominator in the equation, which leaves out long term interest bearing debt used to finance the growth of the company.

The other detail that an investor needs to get used to is not just looking at net profit, which is used in the ROE calculation that they are probably accustomed to seeing, but instead looking at net operating profit after taxes (NOPAT) instead.  The difference in these two numbers is that net profit includes income from all sources, whereas NOPAT looks at income from sales revenue.  Some of the income items that are not included with NOPAT are interest on investments (typically interest that accrues on cash and cash equivalents), revenue from sub-leased office space, etc.  In other words, NOPAT focuses on revenue generated only from the main focus of the business activities of the company you are looking at.

By focusing on after tax net operating profit, and ALL of the capital that a business is using to sustain and grow that cash flow, the time it takes to learn what is return on invested capital can give an investor a much better and deeper view on the health of a company that is being considered as an investment candidate.

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Earnings Yield is a very popular, and useful, tool for investors who try to beat the market with value stocks investing. 

Earnings Yield

Earnings yield can help value stocks investors in their quest to find good solid companies that are currently relatively cheap.  Using indicators like return on invested capital (learn how to calculate ROIC), can be helpful in finding a list solid companies, and once you’ve identified this list, earnings yield can help you determine if the company is cheap enough to buy right now, after all, that is what value stock investing is all about.  Earnings yield does this by dividing a company’s annual earnings per share (you can use a trailing 4 quarters view of EPS for this if you’d like) by the company’s current market price per share.  This number is expressed as a percentage, which makes it easy to compare with bond yields.

How to Calculate Earnings Yield

There are a couple of ways to calculate earnings yield.  Since you don’t find this number in a lot of free online stock screeners, I’ll cover both methods, and you can decide which one you want to use. 

The first way to calculate earnings yield is to take the inverse (1/x) of the P/E ratio.  Since P/E ratios can be found in most financial publications, web sites, and stock screening tools, it is very easy to find this number, and invert it on a calculator or in a spreadsheet, to give you the earnings yield.  This method is very simple to use, and gives you a quick view of how cheap (or expensive) a stock is.

The other way to calculate earnings yield is a little more involved, but gives you a better understanding of how a company is valued relative to it’s earnings.  This form of earnings yield was written about by Joel Greenblatt in his book, “The Little Book That Beats the Market”.  The earnings yield he created is useful in comparing companies with different tax rates and levels of debt.  Greenblatt’s earnings yield formula is:

Earnings yield = pre-tax operating profit (EBIT) / Enterprise Value

So, in this case, the numerator (EBIT) comes from the income statement, and the denominator (Enterprise Value) is calculated by adding the market value of all equity – both common and preferred – to the value of all interest bearing debt that the company owes.  The value of equity is just the shares outstanding multiplied by the price of the stock, and interest bearing debt can be found on the company’s balance sheet.

I like Greenblatt’s method of calculating earnings yield better than the more popular E/P method, since it gives a more accurate view of what is happening inside of a company, and also gives a more balanced view when comparing multiple companies to each other.

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