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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Business revenue growth is a very important fundamental analysis indicator used by investors for picking good value stocks.  To start with lets go over the difference between business revenue and total revenue.  Business revenue is income, or sales, that comes from the primary activities for a given company, whether it is organized as a corporation, partnership, sole-proprietorship, etc., doesn’t matter, business revenue is the same across all types of companies. 

Business revenue does not include other types of revenue that may be included on a given comany’s balance sheet like incidental or non-operating revenue.  Some examples of the types of revenue streams will help you see the difference between non-operating revenue and business revenue.  One example would be incidental revenue earned on a deposit in a demand bank account – this type of revenue is not associated with business revenue generated by the primary activity of the company.  Another type of non-operating revenue that needs to be filtered out of the total revenue number might be from a manufacturing company owning or leasing a building, and sub-leasing a portion of the building that it is not using to another company – again, this is not business revenue, but would show up in the top line number on an income statement.

The focus of your value stock picking should be on business revenue growth, also known as net sales growth.  Examples of business revenue would include a manufacturing company or a bakery selling goods, or an accounting firm or a consulting firm selling services.

Business revenue growth is calculated by dividing this periods (typically quarterly or annual) net sales by last periods net sales and subtracting 1.  This gives you the percent growth, or reduction, in business revenue.  Above average business revenue growth combined with the company efficiency you can find by learning how to calculate ROIC, is a great way to filter stock candidates down to a manageable list.

Good value stocks have business revenue growth that is greater than the company’s peers in it’s industry.  It should have consistent multi-year growth, if there is an anomally in the annual growth rate, make sure you understand why – it could be anything from a recession that took out all company’s growth, to the introduction of a game changing technology that the stock will have a hard time recovering from.

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