ROIC

Return on invested capital (ROIC) is a measurement of a company’s efficiency in using its capital to generate profits. It is calculated by dividing net operating profit after tax (NOPAT) by invested capital.

Comparing a company’s ROIC with its  weighted average cost of capital (WACC) reveals whether the company’s invested capital is being used effectively.

# Formula and Calculation of Return on Invested Capital (ROIC)

The formula for ROIC is:

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

where: NOPAT = Net operating profit after tax.
Written another way:

$$ \text{ROIC} = \frac{\text{Net Income} - \text{Dividends}}{\text{Debt} + \text{Equity}} $$

The ROIC formula is calculated by assessing the value in the denominator, total capital, which is the sum of a company’s debt and equity.

# Calculating Denominator (Debt and Equity)

Source: Return on Invested Capital (ROIC) reformatted by ChatGPT

# Asset-Based Approach (Net Operating Assets)

This method calculates invested capital by starting with total assets and subtracting cash and non-interest-bearing current liabilities (NIBCLs). NIBCLs include liabilities such as accounts payable and tax liabilities, as long as they are not subject to interest or fees.
Formula:
\(\text{Invested Capital} = \text{Total Assets} - \text{Cash} - \text{NIBCLs}\)
This approach aims to isolate the capital actively invested in operations by removing excess liquidity and liabilities that don’t accrue interest.

# Book Value Approach (Equity + Debt - Non-Operating Assets)

This approach calculates invested capital by adding the book value of the company’s equity and debt, then subtracting non-operating assets. Non-operating assets include cash and cash equivalents, marketable securities, and assets of discontinued operations.
Formula:
\(\text{Invested Capital} = \text{Book Value of Equity} + \text{Book Value of Debt} - \text{Non-Operating Assets}\)
This method emphasizes the capital structure (equity + debt) and filters out assets not directly tied to core business operations.

# Working Capital + Fixed Assets Approach

This method begins with calculating working capital by subtracting current liabilities from current assets. Then, it focuses on non-cash working capital by removing cash from the result. Finally, it adds this non-cash working capital to the company’s fixed assets.
Formula:
\(\text{Invested Capital} = (\text{Current Assets} - \text{Current Liabilities} - \text{Cash}) + \text{Fixed Assets}\)
This method is useful for operational analysis, focusing on how much capital is tied up in working assets and fixed infrastructure.

# Calculating Nominator

The value in the numerator can also be calculated in several ways. The most straightforward way is to subtract dividends from a company’s net income.

On the other hand, because a company may have benefited from a one-time source of income unrelated to its core business—a windfall from foreign exchange rate fluctuations, for example—it is often preferable to look at  net operating profit after tax (NOPAT). NOPAT is calculated by adjusting the operating profit for taxes:

\(\text{NOPAT} = \text{Operating Profit} \times (1 - \text{Effective Tax Rate})\)

# What ROIC Can Tell You

Pro Tip

ROIC higher than the cost of capital means a company is healthy and growing, while ROIC lower than the cost of capital suggests an unsustainable business model.

# Limitations of Using ROIC

ROIC is one of the most important and informative valuation metrics. However, it is more important in some sectors than others. Some companies, such as those that operate oil rigs or manufacture semiconductors, invest capital much more intensively than those that require less equipment.

A major downside of this metric is that it tells nothing about what segment of the business is generating value. If you make your calculation based on net income (minus dividends) instead of NOPAT, the result can be even more opaque, since the return may derive from a single, nonrecurring event.