What is Return on Invested Capital?
Return on Invested Capital (ROIC) is a measurement of how efficiently a company is generating profits based on investments into the business.
ROIC is calculated by dividing after tax operating profits by the sum of working capital and fixed assets:
The idea behind calculating Return on Invested Capital is to determine the return a company is getting on the assets required to run the business. A higher number reflects a company that is more efficient in generating profits with each dollar invested.
You may see variations in the definition depending on where you look:
After-Tax Operating Profit may also be called NOPLAT (Net Operating Profit Less Adjusted Taxes).
Usually the working capital used to calculate ROIC is non-cash working capital. You may see (current assets – cash and cash equivalents – current liabilities) in the denominator instead of working capital.
You may also see the denominator simply referred to as ‘Invested Capital’
For an example, let’s take a look at Intel’s most recent 10-K filing and calculate their ROIC:
Intel’s balance sheet: (click to enlarge)
And Intel’s income statement: (click to enlarge)
After tax operating profit = Operating income – Provision for taxes = $10,254
Intel’s working capital = current assets – current liabilities = 35,508 – 20,302 = $15,206 and typically you use non-cash working capital, so subtract Intel’s cash balance (3,225) from its working capital to get $11,981.
Intel’s fixed assets are Property, Plant and Equipment = $36,171, add that to non-cash working capital for a denominator total of $48,152.
$10,254 / $48,152 = .2129 = 21.29%
Intel’s Return on Invested Capital is 21.29%
What Does ROIC Tell Investors?
Companies create value for their shareholders when their Return on Invested Capital is greater than the company’s cost of capital. Companies that can consistently generate high ROIC become compounding machines.
But there is more to running a great company than having a high ROIC.
A company with a high ROIC is not necessarily better. Would you rather have a company with a 50% ROIC with $1 million in invested capital or a company with a 20% ROIC with $1 billion in invested capital? Many companies can produce high returns with a small amount of assets, you want to ensure that a company’s ROIC is steady, or increasing as assets increase too. The fact that Intel has been able to achieve high ROIC even with tens of billions in assets is one reason it has produced such stellar returns for shareholders.
ROIC could easily be manipulated higher for a couple years to make a company look good in the short term, but at the expense of long term success. Intel could improve their ROIC by avoiding R&D spending or reducing inventories, but that may not be best over the long term.
Because of this, potential investors want to ensure ROIC has been steady over time.
When in ROIC Useful?
Calculating a company’s return on invested capital is most useful when evaluating capital intensive companies. Think semiconductor manufacturing, oil drilling, mining. And should only be used to compare companies in the same industry. Companies that have very low fixed assets such as software or services companies may appear to have high ROIC values, but it is not really comparable to the ROIC of a capital intensive business. For example, comparing Facebook’s return on invested capital to Intel’s, and assuming Facebook is the better investment because of a higher ROIC would not be a fair assumption.
Return on Invested Capital measures the performance of the company’s core business (remember, we use Operating Income), so income generated by other “non-core” aspects of the business, such as equity investments or selling old real estate, do not affect a company’s ROIC.
But a company’s ROIC is only relevant if the company’s cost of capital is lower than the company’s ROIC. If a company is generating 10% return on invested capital, but they are paying 10% to get that capital (through borrowing, issuing shares, etc.), the company is not creating any value. A company may be showing growth in earnings, but if its cost of capital is greater than its return on invested capital, the company is destroying value.