How is Return on Invested Capital Calculated
Know a Company's ROIC to Evaluate It as an Investment
When you invest in a business, whether as a principal of a small company or as a stockholder in an international corporation, an important and fundamental question to ask is: what's the annual return on my investment?
Return on Invested Capital (ROIC) is a profitability or performance ratio that measures how much investors in a business are earning on the capital invested. As an example of financial analysis, return on invested capital is also a valuable valuation measure.The stock market, for instance, has returned about 9 percent annually for more than 100 years.
It provides a useful benchmark -- if you're consistently getting a return that beats inflation (the 9 percent figure doesn't take inflation into account) by another 5 to 7 percent return, that's not at all bad. If, on the other hand, your return on investment barely beats inflation or even falls below the inflation rate, the ROI is less than satisfactory.
The Return on Invested Capital Calculation
You have to look at a company's financial statements to understand return on invested capital. Look at the income statement. You will see a line item for Earnings Before Interest and Taxes (EBIT). If you multiple EBIT by (1-tax rate), you arrive at Net Operating Profit after Taxes or NOPAT. NOPAT is the numerator in the equation calculating Return on Invested Capital. Sometimes, EBIT is substituted as the numerator.
NOPAT = EBIT (1 - tax rate) = Numerator
We have the numerator in the equation to calculate Return on Invested Capital, so now we need the denominator.
The denominator is Operating Capital. We look at the balance sheet for this information since the accounts that makeup capital are there.
Operating Capital is made up of notes payable, long-term bonds, preferred stock, and common equity. Here we'll assume a simple balance sheet that only has notes payable (the long-term bank loan entry) and common equity accounts.
A more sophisticated balance sheet may have bonds and preferred stock on it as well. Operating capital, the denominator, is calculated by adding the average debt liabilities to the average stockholder's equity:
Operating Capital = Average Debt Liabilities + Average Stockholder's Equity = Denominator
Given this information, here is the formula for Return on Invested Capital:
ROIC or ROCE = NOPAT/Operating Capital
How do you Interpret Return on Invested Capital?
Return on Invested Capital is a performance measure indicating how much return is generated by each dollar of operating capital. If the ROIC is greater than the firm's weighted average cost of capital, then the business is adding value.
Calculating the weighted average cost of capital (WACC) isn't difficult, but gathering the necessary data needed to make the calculation is burdensome (average cost of debt, corporate tax rate, cost of equity and more). But, fortunately, it's also unnecessary. Any major brokerage, including most of the online brokerages, will have its own analyst reports for every major corporation, and each report will include the WACC.
Once you have the WACC, you have a valuable decision-making tool. Suppose, for instance, that a company has a 15% ROIC and a WACC of 8%.
It means that the company is returning a net 7% to its investors. Depending on the general economic environment, this could be good or bad -- it's probably somewhere in the middle. If, on the other hand, the company's ROIC is 8% and its WACC is 9%, that's not good, and your appropriate decision would be not to buy that company's stock.