ROIC Growth Formula

The ROIC growth formula relies on evaluating return on invested capital (also known as ROIC) as a way of looking at stocks that helps smart value investors find good stocks to buy.  First let’s look at what is return on invested capital, then we’ll examine why companies with comparatively large values of this key performance indicator tend to outperform their competition over time (and make good value investment candidates).

The first step in the ROIC growth formula is understanding how to calculate ROIC for the companies that you are thinking about investing in, so here is the formula:

(Net Operating Profit After Taxes) / (Invested Capital)

Now there are a couple of things that must be noted about this formula.  First, net operating profit after tax (NOPAT)is not the same thing as net income.  Net income counts money that a company receives from all sources, whereas NOPAT is derived from the sales that a business makes from the ongoing operations of its main business.  Some of the revenue that is not included in NOPAT are things like interest income from cash and cash equivalents (short term securities like T-Bills), and rent from real estate that the company may own, but sub-leases to other businesses because it is not currently needed by the company.  These types of revenue, that are not from sales of the companies main products and services, add noise to what we are seeking – a clear view of the company’s operating efficiency – so we take them out of the equation.  The second thing that we have to consider is that invested capital is not just equity (like what is used in return on equity (ROE) calculations), but also includes long term debt that is used to grow and sustain the business.

The ROIC growth formula is fairly simple – calculate the return on invested capital for the companies in the industry group you are considering investing in, identify the company with the highest value of this indicator, then buy it when it gets to a good price.  By comparing the return on invested capital values of companies in the same industry, the one with the highest return is likely to either continue dominating the industry, or, if it is not already dominating its industry, should outperform the industry over time.  If you think about it, the company with the highest return on invested capital is yielding a higher percentage of profit for every dollar invested in the company - either by equity share holders or debt bond holders.  The competitive advantage that allows a company to earn these higher than industry average returns are usually due to a dominating position in the market place, which makes it possible for them to charge more for their product or service relative to their cost, which leaves other companies in the sector competing based on price discounting (and lower margins).  Over time, this sustained competitive advantage allows the company with higher returns on invested capital to grow faster than its competition, which drives its stock price higher.

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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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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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