After-tax operating income divided by the book value of debt and equity capital less cash equivalents
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ROIC stands for Return on Invested Capital and is a profitability or performance ratio that aims to measure the percentage return that a company earns on invested capital. The ratio shows how efficiently a company is using the investors’ funds to generate income. Benchmarking companies use the ROIC ratio to compute the value of other companies.
Return on Invested Capital is calculated by taking into account the cost of the investment and the returns generated. Returns are all the earnings acquired after taxes but before interest is paid. The value of an investment is calculated by subtracting all current long-term liabilities, those due within the year, from the company’s assets.
The cost of investment can either be the total amount of assets a company requires to run its business or the amount of financing from creditors or shareholders. The return is then divided by the cost of investment.
A company can evaluate its growth by looking at its return on invested capital ratio. Any firm earning excess returns on investments totaling more than the cost of acquiring the capital is a value creator and, therefore, usually trades at a premium. Excess returns may be reinvested, thus securing future growth for the company. An investment whose returns are equal to or less than the cost of capital is a value destroyer.
Generally speaking, a company is considered to be a value creator if its ROIC is at least two percent more than the cost of capital; a value destroyer is typically defined as any company whose ROIC is two percent less than its cost of capital. There are some companies that run at zero returns, whose return percentage on the value of capital lies within the set estimation error, which in this case is 2%.
Calculating the ROIC for a Company
A company’s return on invested capital can be calculated by using the following formula:
The book value is considered more appropriate to use for this calculation than the market value. The return on capital invested calculated using market value for a rapidly growing company may result in a misleading number. The reason for this is that market value tends to incorporate future expectations.
Also, the market value gives the value of existing assets to reflect the business’ earning power. In a case where there are no growth assets, the market value may mean that the return on capital equals the cost of capital.
To get the invested capital for firms with minority holdings in companies that are viewed as non-operating assets, the fixed assets are added to the working capital. Alternatively, for a company with long-term liabilities that are not regarded as a debt, add the fixed assets and the current assets and subtract current liabilities and cash to calculate the book value of invested capital.
The return on invested capital should reflect the total returns earned on the capital invested in all of the projects listed on the company’s books, with that amount compared to the company’s cost of capital.
Determining a Company’s Competitiveness
A business is defined as competitive if it earns a higher profit than its competitors. A company becomes competitive mainly when its production cost per unit is lower than that of its competitors.
Competitive advantages can be analyzed from either a production or consumption viewpoint. A company has a production advantage when it can supply goods and services at a lower price than competitors are able to match. It has an advantage from a consumption perspective when it can supply goods or services difficult for other competitors to imitate. The ROIC ratio helps to determine the length or durability of a firm’s competitive advantages. Following is an alternative formula for calculating the ROIC:
NOPAT/Sales ratio is an amplitude of profit per margin, whereas Sales/Invested capital is a measure of capital efficiency.
The sales cancel out, and the NOPAT/Invested Capital is left, which is the ROIC. When a firm acquires a high ROIC due to a high NOPAT margin, the competitive analysis is based on the consumption advantage. Alternatively, if the returns are due to a high turnover ratio, then the company’s relative competitiveness is a result of a production advantage.
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Aswath Damodaran on ROIC
Aswath Damodaran is a lecturer at the New York University Stern School of Business, teaching corporate finance, valuation, and investment philosophies. Damodaran has written on the subjects of equity risk premiums, cash flows, and other valuation-related topics.
He’s been published in several leading financial journals, such as the Journal of Financial Economics, Review of Financial Studies, The Journal of Financial and Quantitative Analysis, and The Journal of Finance. He is also the author of a number of books on valuation, corporate finance, and investments.
Damodaran provides updates on industry averages for US-based and global companies that are used for calculating company valuation measures. He publishes datasets every year in January, and the data is grouped into 94 industry groupings. The groupings are self-derived but based on the S&P Capital IQ and Value line categorizations.
Corporate finance data is broken down into profitability and return measures, financial leverage measures, and dividend policy measures. In valuation, he focuses on risk parameters, risk premiums for equity and debt, cash flow, and growth rates.
Damodaran also publishes risk premium forecasts for the United States and other markets. The US risk premiums are based on a two-stage Augmented Dividend discount model. The model reflects risk premiums that justify current levels of dividend yield, expected growth in earnings, and the level of the long-term bond interest rate.
Damodaran began computing the implied equity risk premiums data for the United States in 1960. The risk premiums for other markets are based on the ratings assigned to individual countries by Moody’s, one of the big three rating agencies in the United States.
Video Explanation of Return on Invested Capital (ROIC)
Watch this short video to quickly understand the main concepts covered in this guide, including the definition and the formula for calculating return on invested capital (ROIC).
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