Return on Invested Capital (ROIC)

Return on Invested Capital Calculation Example (ROIC)

The ROIC ratio quantifies the profits that the company can generate for each dollar of capital invested into the company in the form of a percentage.

Simply put, the profits generated are compared to the average capital invested in the current and prior period.

If a company generated $10 million in profits and invested an average of $100 million in each of the past two years, the ROIC is equal to 10%.

• Return on Invested Capital (ROIC) = $10m ÷ $100m = 10%

The 10% ROIC implies that the company generates $10 of net earnings per $100 invested in the company.

What is a Good ROIC? (%)

ROIC is one method to determine whether or not a company has a defensible “economic moat“, which is the ability of a company to protect its profit margins and market share from new market entrants over the long run.

The overall objective of calculating the metric is to grasp a better understanding of how efficiently a company has been utilizing its operating capital (i.e. deployment of capital).

For investors in the public markets, the metric is frequently used to screen for potential investments, not just for retail investors but for institutional investors such as hedge funds — especially funds utilizing long-only, value-oriented strategies.

^{Warren Buffett on Economic Moats (Source: 2007 Berkshire Hathaway Shareholder Letter)}

Finding public companies in the stock market with an actual “moat” and consistently above-market ROICs is without a doubt easier said than done, but one that can yield high investment returns.

The reason that the ROIC concept tends to be prioritized by value investors is that the majority of investors purchase shares under the mindset of a long-term holding period.

Hence, current earnings and cash flows are a relatively small component of the total net return — instead, the ability to reinvest those earnings to build real value is much more important.

Generally, the higher the return on invested capital (ROIC), the more likely the company is to achieve sustainable long-term value creation.

Companies with high returns on invested capital are more likely to continue employing capital thoughtfully to achieve returns in line with the past (or similar) – it is usually very rare to come across such opportunities at the right time and share price.

Learn More → Calculating Return on Invested Capital (Michael J. Mauboussin)

How to Interpret Return on Invested Capital (ROIC vs. WACC)

One common way to use ROIC as an investment decision-making tool is to compare the investment’s ROIC to its weighted average cost of capital (WACC).

Comparing the ROIC to the WACC can help decide whether or not the company creates sufficient value for its stakeholders.

If the ROIC is higher than the WACC, that means the company creates positive value, whereas if the ROIC is lower than the WACC, that means the company’s value is declining.

• If ROIC > WACC → “Invest”
• If ROIC < WACC → “Pass”

Companies that generate an ROIC above their cost of capital implies the management team can allocate capital efficiently and invest in profitable projects, which is a competitive advantage in itself.

When investors screen for potential investments, the minimum ROIC tends to be set between 10% and 15%, but this will be firm-specific and will depend on the type of strategy employed.

Learn More → ROIC by Sector (Damodaran)

Full Form ROIC Formula: Value Driver Components

From the expanded full form formula of ROIC, we can see the value is the product of:

• Invested Capital Turnover: “How much revenue does each dollar of invested capital generate?”
• Margins (%): “How much in profits are retained after deducting the cost of goods sold (COGS) and operating expenses (OpEx) to arrive at operating income (EBIT), which is then tax-affected?

The underlying components of the ROIC metric, at its core, is reflected in the following equation.

NWC affects invested capital since if operating assets increase, invested capital increases as well – which in turn decreases the metric (i.e. more spending is needed to sustain or increase growth).

Conversely, if operating liabilities were to increase, ROIC would increase because NWC is lower.

A higher return on invested capital can be considered an indication that a company is required to spend less to generate more profit.

• Profitable Returns on Invested Capital → Positive Value Creation and Shareholder Returns

The higher the profit margins of the company, the higher the return on invested capital, as the company can convert more revenue into profits, or NOPAT, to be more specific.

How to Improve ROIC: Firm Value Creation Methods

Namely, there are five predominant methods for corporations to create positive economic value over the long run:

1. Invest in High Return, Profitable Projects – i.e. ROIC > WACC (“Value Creating”)
2. Improve Capital Efficiency,  e.g. Higher Asset Turnover, Higher Inventory Turnover, Revenue Maximization
3. Implement Operating Improvements,  i.e. Higher Profit Margins, Reduce Unnecessary Spending
4. Optimize Capital Structure, i.e. Potentially Lower WACC from Issuance of Debt
5. Identify and End “Value Destroying” Projects, i.e. NPV < 0

Importance of Understanding Growth and ROIC Ratio (%)

Contrary to a common misunderstanding, growth is not always a positive signal for a company.

The question that must be asked is, “At what cost was the growth obtained?”

Often, companies will make significant investments to expand, but if the ROIC is lower than the cost of capital (WACC), the Capex destroys value as opposed to creating shareholder value.

• Scenario A: In Scenario A, the change in invested capital was $25m more for an increase of $5m in NOPAT.
• Scenario B: In contrast, in Scenario B, the NOPAT increased by $5m too, but $150m was spent, so focusing on growth in NOPAT by itself would be misleading in the latter case.

ROIC Calculator – Excel Template

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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Step 1. NOPAT Calculation Example

Suppose we’re tasked with calculating the return on invested capital (ROIC) of a company with the following financial profile as of Year 0.

• Year 0 Revenue = $200 million
• Year 0 Operating Income (EBIT) = $50 million
• Tax Rate = 30%

From Year 0 to Year 5, revenue is projected to grow $2m per year while EBIT grows $4m per year under the same time horizon, as shown below. To reflect this, we’ll use step functions as seen on the right side of the model.

The NOPAT margin (% of revenue) expanded from 17.5% in Year 0 to 23.3% in Year 5.

Based on these sets of assumptions, note the growth of NOPAT is outpacing revenue, which will increase the likelihood of ROIC increasing – unless the invested capital offsets the margin expansion.

Step 2. Invested Capital Calculation Example

Next, we’ll calculate the invested capital, which represents the net operating assets used to generate cash flow.

For the working capital schedule and fixed assets forecast, the following assumptions will be used:

• Accounts Receivable (A/R) = $80 million
• Inventories = $50 million
• Accounts Payable (A/P) = $40 million
• Other Current Liabilities = $10 million
• PP&E = $260 million

The company’s net working capital (NWC) can be calculated by subtracting the current liabilities (excluding debt and interest-bearing securities) from the current assets (excluding cash & cash equivalents).

All operating current assets are projected to decline by $2m each year, whereas the operating current liabilities are forecasted to grow by $2m each year. And the PP&E balance will grow by $5m each year.

Step 3. ROIC Calculation Example (%)

Once the entire forecast has been filled, we can calculate the ROIC in each period by dividing NOPAT by the average between the current and prior period invested capital balance.

Starting from Year 1 to Year 5, we can see an increase from 11.2% to 15.0%, which is caused by the increased profit margins and the increase in operating current liabilities.

Since the invested capital is declining while the revenue and NOPAT are growing at a higher pace, the ROIC is rising because more value is being derived from the invested capital.

The takeaway here is that the more revenue generated per dollar of invested capital and the higher the profit margins, the higher the return on invested capital will be — all else being equal.

In the final step, we multiply the NOPAT margin % by the average invested capital balance of the current and prior year to get the same ROICs, which confirms our calculations were done correctly.