The return on invested capital (ROIC) is a performance metric that measures the profitability of a company relative to the money that its investors have put in. Along with return on equity (ROE), it is one of the more common profitability ratios investors can use to gauge a company’s health.
You can calculate the return on invested capital by dividing the net operating profit after tax (NOPAT) (numerator) by the invested capital (denominator), then multiplying the result by 100 to express it as a percentage. All the information you need is available on standard financial statements companies release regularly.
What Is Return on Invested Capital?
Plenty of ways exist for you to judge a company’s performance. The return on invested capital, or ROIC, calculation is one of them. It is usually used to determine the profits the company generates after investing its investors’ monies (capital structure or money raised by both debt and equity) to generate more revenue.
It is worth noting that the return on invested capital considers the overall return on capital invested, instead of the returns of individual assets. However, ROIC doesn’t factor dividends, since these are usually returned to the stockholders. That said, ROIC is an excellent strategy for comparing various companies across many industries to determine which one has the best-performing management team that brings the best return on investment (ROI).
It is sometimes compared to the weighted average cost of capital (WACC), which is the average rate of payment companies incur to finance their assets. WACC usually considers the after-tax cost of all capital sources, including common stock, bonds and other types of debt.
What Is a Good ROIC?
The general rule of thumb is that companies should have a return on invested capital of 2 percent or more. Otherwise, they aren’t creating value for their shareholders. So, a higher return on invested capital is better.
Return on Invested Capital Formula
Below is the summarized ROIC formula you can use to calculate the return on invested capital.
Return on invested capital (ROIC) = (Net Operating Profit after Tax (NOPAT)/Average Invested Capital)
You can then multiply the result by 100 percent to obtain the final result.
Net Operating Profit After Tax
The net operating profit after tax, or NOPAT, is the company’s after-tax income from the business operations, assuming it has no debt in its working structure and, thus, no interest expense. It also ignores non-operating income taxes.
According to the Corporate Finance Institute, you can obtain NOPAT by using the following simple formula:
NOPAT = Business Operation Income* (1 - tax rate)
Alternatively, you can use:
NOPAT = Earnings Before Interest and Tax (EBIT)* (1- corporate tax rate)
CFI advises that you can also use a more complex formula:
NOPAT = Net Income + Tax Expense+ Interest Expense + Non-Operating Gains/Losses * (1 - tax rate)
Typically, you can find EBIT from the company’s income statement by identifying the revenue, cost of goods sold and operating expenses. Then you can use the following formula to deduce EBIT:
EBIT = Total Company Revenue - Cost of Goods Sold (COGS) - Operating Expenses
Also, you can find the company’s marginal corporate tax rate on its annual reports. The Tax Foundation currently puts the average federal corporate tax rate at 21 percent.
Once you determine EBIT and the corporate tax rate, you can calculate NOPAT easily.
Invested capital is the funding that has been raised via equity and debt to run the daily business operations and grow the company. It is different from working capital, which helps measure the company’s cash flow or liquidity.
You can easily find the book value of invested capital on a company’s balance sheet. The SEC.gov EDGAR search tool makes finding such financial information pretty easy. One method is to add the shareholders’ equity to the interest-bearing debt (including capital lease obligations) to obtain the invested capital.
Alternatively, you can subtract non-interest-bearing liabilities, such as interest payable from current assets, then add operating assets, such as goodwill, plants, equipment and real estate, to obtain the invested capital.
Calculating Return on Invested Capital
Below are the steps you can take to calculate the ROIC ratio.
- Identify the company whose ROIC ratio you want to calculate and find the income statement on its Form 10-K report, available on the SEC.gov website or the company’s investor relations website.
- Find out the relevant information for calculating NOPAT, including the total revenue, cost of goods sold, operating expenses and the company’s corporate tax rate. For example, suppose company XYZ had total annual revenue of $10 million, COGS worth $1.5 million and operating expenses worth $2.5 million. Also, suppose the company pays a tax rate of 21 percent, which is equivalent to 0.21.
- Also find the balance sheet of the company within the same Form 10-K report and determine the invested capital. Assume in this case that the invested capital from interest-bearing debt and shareholders’ equity is $20 million.
- Based on the information available, you can first calculate EBIT using the above formula. So, using this example: EBIT = $(10 million – 1.5 million - 2.5 million) = $6 million.
- You can then calculate NOPAT as follows: NOPAT = EBIT (1-corporate tax rate) = $6 million (1-0.21) = $6 million*0.79 = $4.74 million.
- Since the invested capital is $20 million, you can obtain the ROIC ratio by dividing NOPAT by $20 million. So, in this case, you would calculate: $4.74 million/$20 million = 0.237.
- Multiply the ROIC ratio by 100 percent to obtain the final value in the form of a percentage. So, ROIC = 0.237*100 = 23.7 percent.
- You can conclude that company XYZ creates value for its investors, since the ROIC calculation is more than 2 percent.
When doing company valuations, a higher return on invested capital ratio indicates the company in question is better managed on behalf of its shareholders and the company’s profitability is higher. And those with ROICs of more than 2 percent are creating value.
On the other hand, companies with lower returns in general, or return on invested capital lower than 2 percent, are either performing poorly compared to the competition or not creating any value for their shareholders at all.
But to be sure of the company’s performance using this metric, you should also consider the industry average. Some industries are more capital-intensive than others.
- Compare a company’s ROIC over different periods to identify any positive or negative trends.
- ROIC varies among industries. Compare a company’s ROIC with those of its competitors to see how it measures up to its peers.
I hold a BS in Computer Science and have been a freelance writer since 2011. When I am not writing, I enjoy reading, watching cooking and lifestyle shows, and fantasizing about world travels.