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A calculation used to assess a company's efficiency at allocating the capital under its control to
profitable investments. Return on invested capital gives a sense of how well a company is using
its money to generate returns. Comparing a company's return on capital (ROIC) with its
weighted average cost of capital (WACC) reveals whether invested capital is being used
effectively.
Invested capital, the value in the denominator, is the sum of a company's debt and equity. There
are a number of ways to calculate this value. One is to subtract cash and non-interest bearing
current liabilities (NIBCL) including tax liabilities and accounts payable, as long as these are
not subject to interest or fees from total assets.
Another method of calculating invested capital is to add the book value of a company's equity to
the book value of its debt, then subtract non-operating assets, including cash and cash
equivalents, marketable securities and assets of discontinued operations.
Yet another way to calculate invested capital is to obtain working capital by subtracting current
liabilities from current assets. Next you obtain non-cash working capital by subtracting cash
from the working capital value you just calculated. Finally non-cash working capital is added to
a company's fixed assets, also known as long-term or non-current assets.
The value in the numerator can also be calculated in a number of 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 taxes (NOPAT). NOPAT is calculated
by adjusting the operating profit for taxes: (operating profit) * (1 - effective tax rate). Many
companies will report their effective tax rates for the quarter or fiscal year in their earnings
releases, but not all. Operating profit is also referred to as earnings before interest and tax
(EBIT).
ROIC provides necessary context for other metrics such as the P/E ratio. Viewed in isolation, the
P/E ratio might suggest a company is oversold, but the decline could be due to the fact that the
company is no longer generating value for shareholders at the same rateor at all. On the other
hand, companies that consistently generate high rates of return on invested capital probably
deserve to trade at a premium to other stocks, even if their P/E ratios seem prohibitively high.
In Target Corp.'s (TGT) first-quarter 2015 earnings release, the company calculates its trailing
twelve month ROIC, showing the components that go into the calculation:
TTM TTM
(All values in million of U.S. dollars)
5/2/15 5/3/14
This calculation would have been difficult to obtain from the income statement and balance sheet
alone, since the asterisked values are buried in an addendum. For this reason calculating
ROIC can be tricky, but it is worth arriving at a ballpark figure in order to assess a company's
efficiency at putting capital to work. Whether 12.5% is a good result or not depends on Target's
cost of capital. Since this is often between 8% and 12%, it is likely that Target is creating value,
but slowly and with a thin margin for error.
To learn how to use ROIC for investment selection, please read Find Quality Investments With
ROIC.