What is ROIC?

ROIC stands for Return on Invested Capital, and is a profitability or performance

ratio that aims to measure the percentage return that investors in a company are
earning from their invested capital. The ratio shows how efficiently a company is
using the investors’ funds to generate income. Benchmarking companies use
ROIC ratio to compute the value of other companies.

ROIC Formula

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 interests are 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.

Note: NOPAT is equal to EBIT x (1 – tax rate)

Determining the Value of a Company

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 less than two percent greater 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, 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 currents 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.