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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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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