What is Return on Invested Capital?
Return on Invested Capital is a profitability or performance measure of the return earned by those who provide capital, namely the firm’s bondholders and stockholders. Return on Invested Capital (ROIC) can be defined as follows:
There are three key insights to be gained from this definition:
- We use after-tax operating income (NOPAT) rather than net income because it must consider earnings to not only stockholders (net income), but also to bondholders (interest)
- We use book value of debt and equity rather than market value because market value incorporates expectations for the future, but book value removes these expectations to isolate a measure of current profitability. Furthermore, we net out cash because the interest income from cash is not a component of operating income.
- We account for the timing difference as the capital must first be invested before the invested capital begins generating earnings. Some analysts will opt to take an average of the invested capital in the prior and current period.
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Return on Invested Capital and WACC
The primary reason for comparing a firm’s return on invested capital to its WACC is to know whether the company destroys or creates value. If the ROIC is greater than WACC, value is being created as the firm invests in profitable projects. Conversely, if the ROIC is lower than WACC, value is being destroyed as the firm earns a return on its projects that is lower than the cost of funding the projects.
In macroeconomic theory, when a firm gains economic profits in a certain industry, there is an incentive created for new entrants to compete for profits until there are no more economic, or growth, profits to be made, only normal profits. A firm being able to consistently earn an ROIC greater than its WACC is an indicator of a strong economic moat and of the firm’s ability to sustain its competitive advantage. Following this logic, it would make sense to assume that ROIC converges to WACC in the long run.
A Robust Measure of Profitability
Return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC) are three ratios that are commonly used to determine a firm’s ability to generate returns on its capital, but ROIC is more informative than either ROA and ROE.
ROA is calculated by taking net income over total assets and is used to compare firms in the same industry. However, ROA can be substantially skewed either high or low based on a firm’s cash balance.
ROE is calculated as net income over shareholders’ equity and is used to compare firms with the same capital structure. However, ROE can be positively impacted by actions that reduce shareholder equity (i.e. write-downs, share buybacks) but that does nothing to net income. Another limitation to ROE is that a firm may take on excess leverage and still look as if they are handling things well.
ROIC addresses the issues with ROA and ROE in calculating profitability. Cash is netted out when solving for invested capital in the denominator, solving the issue of differences in cash balances across firms. Furthermore, we can compare ROIC across firms with different capital structures, since NOPAT in the numerator is a measure of earnings available to all of the providers of capital.
Return on Invested Capital in Practice
Return on Invested Capital is a measure of return that can be useful to all professions in finance. Portfolio managers can compare the spread between WACC and ROIC to identify value across investments. Research analysts use ROIC to sense-check their financial model’s forecast assumptions (e.g., no perpetual ROIC growth). Management teams use ROIC to plan capital allocation strategies and benchmark investment opportunities. Investment bankers use ROIC to pitch appropriate financial advisory services and benchmark valuations.
It is critical for both companies and their investors to be able to measure how well a company is performing with the capital it is provided with. The following resources can help you become more skilled at investment analysis and business valuation.