Return on Invested Capital: Definition, Formula, Calculation, and Example

Comprehensive overview of Return on Invested Capital (ROIC) including its definition, calculation formula, steps to calculate, and a practical example to help understand its application.

Return on Invested Capital (ROIC) is a financial metric used to measure a company’s efficiency at allocating the capital under its control to profitable investments. It essentially indicates how well a company is generating returns from its capital, whether from debt or equity, encompassing both short-term and long-term investments.

Formula for ROIC

The formula to calculate ROIC is:

$$ \text{ROIC} = \frac{\text{Net Operating Profit After Taxes (NOPAT)}}{\text{Total Invested Capital}} $$

Where:

• Net Operating Profit After Taxes (NOPAT): This is a company’s potential cash earnings if it had no debt. It is derived from operating income minus taxes.
• Total Invested Capital: This is the total capital provided to a company by both equity shareholders and debt holders. It includes both equity and debt minus non-operating assets such as cash and equivalents.

Steps to Calculate ROIC

Step 1: Determine NOPAT

Calculate the Net Operating Profit After Taxes (NOPAT), which can be derived using the formula:

$$ \text{NOPAT} = \text{Operating Income} \times (1 - \text{Tax Rate}) $$

Step 2: Calculate Total Invested Capital

Total Invested Capital is the sum of a company’s debt and equity minus non-operating assets. It can be depicted as:

$$ \text{Total Invested Capital} = \text{Debt} + \text{Equity} - \text{Non-operating Assets} $$

Step 3: Apply the ROIC Formula

Once NOPAT and Total Invested Capital have been determined, apply the ROIC formula:

$$ \text{ROIC} = \frac{\text{NOPAT}}{\text{Total Invested Capital}} $$

Example of ROIC Calculation

Suppose Company XYZ has an Operating Income of $500,000 and is subject to a tax rate of 30%. The company’s Total Debt is $1,000,000, and Equity is $2,000,000. The company holds $200,000 in cash.

• Calculate NOPAT:

  $$ \text{NOPAT} = \$500,000 \times (1 - 0.3) = \$500,000 \times 0.7 = \$350,000 $$

• Calculate Total Invested Capital:

  $$ \text{Total Invested Capital} = \$1,000,000 + \$2,000,000 - \$200,000 = \$2,800,000 $$

• Apply the ROIC Formula:

  $$ \text{ROIC} = \frac{\$350,000}{\$2,800,000} = 0.125 \text{ or } 12.5\% $$

Therefore, Company XYZ’s ROIC is 12.5%.

Importance of ROIC

ROIC is a crucial metric for investors and management because:

• Performance Indicator: It serves as an indicator of a company’s ability to generate value from its investments.
• Investment Decisions: Helps investors compare the efficiency of capital allocation across different companies.
• Management Efficiency: Provides insight into management’s efficiency in deploying capital to generate profits.

Historical Context

The concept of return on invested capital has been utilized for decades as a means of assessing the efficiency of capital utilization. It gained prominence in the 20th century with increased emphasis on performance metrics and shareholder value.

Comparisons and Related Terms

• Return on Equity (ROE): Unlike ROIC, which considers both equity and debt, ROE only measures returns generated on shareholders’ equity.
• Return on Assets (ROA): Measures profitability relative to total assets, disregarding the specific sources of capital.
• Economic Value Added (EVA): A measure of a company’s financial performance calculated as NOPAT minus a charge for the opportunity cost of capital employed.

FAQs

Why is ROIC important to investors?

ROIC indicates how efficiently a company is using its capital to generate profits, helping investors gauge the potential return on their investment.

How can a company improve its ROIC?

A company can improve its ROIC by increasing its NOPAT, reducing costs, improving operational efficiencies, or better managing its invested capital.

What is a good ROIC value?

A good ROIC is typically one that is higher than the company’s weighted average cost of capital (WACC), signifying that the company is generating value.

References

1. Damodaran, A. (2002). Investment Valuation: Tools and Techniques for Determining the Value of any Asset, 2nd Edition.
2. Koller, T., Goedhart, M., & Wessels, D. (2015). Valuation: Measuring and Managing the Value of Companies, University Edition, 6th Edition.

Summary

Return on Invested Capital (ROIC) is a vital measure for evaluating how effectively a company allocates its capital to generate profits. By understanding and utilizing ROIC, investors and management can make informed decisions that contribute to sustainable value creation and improved financial performance.