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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Lets look at how to calculate ROIC (Return on Invested Capital).  I make no secret that ROIC is one of my favorite value stock investing tools.   Learning how to calculate ROIC is relatively easy, and will require you to look at a company’s financial reports to get the numbers you need to calculate ROIC.

The formula for how to calculate ROIC is:

ROIC = ((Net Operating Profit – Income Tax) / (long term debt + equity))

 ROIC calculations look like they have a lot going on, but I’ll now show you how easy it is to get everything so you can calculate ROIC.

Lets use Walgreens in 2007 as an example of how to calculate ROIC, click here for the data you’ll need to follow along with this ROIC example.

From the Income statement, the numerator in the ROIC calculation (Net Operating Profit - Taxes) is 2041.3, you can find this about half way down the page.

The next step to learn how to calculate ROIC is to determine the denominator, so we’ll look at the Balance Sheet tab on the above Walgreens data, and find equity is 11,104.3, and long term debt (+ other liabilities) is 1284.8, which means the ROIC denominator is 12389.1.

So ROIC is 2041.3/12389.1 = 15.5%

Now you know how to calculate ROIC.

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ROIC, or  Return On Invested Capital, is one of my favorite value investing indicators for trying to forecast the financial performance of a company’s stock.  If you think about earnings growth at a high level, most companies have to pay a price to achieve earnings growth – by issuing stock, selling long term bonds (debt), investing in assets, and/or investing in working capital.  ROIC is a superior way to measure this cost to achieve growth, and to compare one company’s financial performance to another company’s, or for that matter, to the performance of an industry group as a whole.  In a nutshell, ROIC is a way of determining the amount of cash earnings a company produces for every dollar invested, and is a primary tool for value investing, along with equity growth rate, earnings yield, and free cash flow growth.

You may already be familiar with one of the cousins of ROIC – Return on Equity (ROE).  ROE, which divides net income by the average shareholder equity over the time period being examined, is also a good measure of a company’s financial performance, and a favorite stock value indicator among value investors.  Click here if you want to learn more about what is Return On Equity.  The downside of ROE is that it does not take into account certain balance sheet liabilities that are being used to power a company’s growth, thus ROE may overstate the company’s economic efficiency.  ROIC corrects this issue, which is why I like it better than ROE.

ROIC is a good way to measure the quality of earnings growth, and is calculated with Net Operating Profit After Taxes (NOPAT) to focus on that earnings quality.  Lets use an example:  Company ABC sells a popular line of widgets, and earned $20 million last year.  This year, they decide to expand, and take on $20 billion in debt to finance that growth.  They are successful, and their earning double to $40 million.  Investors focusing on earnings growth are ecstatic – the company doubled it’s yearly earnings.  ROIC investors, however, are probably running for the exits, because they see that while the company doubled it’s earnings, the debt the company took on to finance that earnings growth only yielded a 1% return ($20 million divided by $20 billion), which is a very inefficient use of dollars invested in the company.  ROIC, unlike ROE or earnings growth, will highlight that inefficient use of dollars.  Investors looking for value stocks should look for high returns on invested dollars, as represented by ROIC, in addition to other key fundamental measures like business revenue growth.

Next up we will look at how to calculate ROIC.

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