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What’s it: Return on invested capital (ROIC) is a profitability ratio to measure how much profit is generated for every dollar invested in the company. We calculate it by dividing net income by the total invested capital, expressed as a percentage. A high and increasing ratio from year to year is more desirable, indicating more returns to shareholders and creditors.
Why is the return on invested capital important?
Return on invested capital (ROIC) measures a company’s ability to leverage its capital to generate profits and returns for shareholders and creditors. Shareholders and creditors provide capital to the company. Shareholders contribute equity capital. Meanwhile, creditors provide debt capital.
Shareholders and creditors take the risk when providing capital to a company. Therefore, they are willing to provide capital if it earns a higher return than its competitors.
Several reasons explain why return on invested capital is important.
First, we can use it to assess how competitive a company is. If a company has a competitive advantage, it should generate a superior ROIC compared to its competitors. And, they must achieve a sustainable competitive advantage to maintain above-average ROIC.
Second, Porter uses it as a measure of industry profitability. He then relates them to the degree of competition in each industry, considering Porter’s five forces. Higher competition depresses profits in the industry, resulting in lower returns.
These five forces explain why certain industries have higher profitability than others. The pharmaceutical industry, for example, has consistently high ROIC thanks to high barriers to entry.
Third, generating above-average ROIC is one way to increase shareholder value. Shareholders expect the company’s share price to continue to rise when it manages to book a higher ROIC than the cost of capital. In addition, they also hope that the company will continue to distribute dividends given the high profitability.
Specifically, a company is considered to create value when it generates a return 2% higher than the cost of capital. As a result, the company is usually the target of stock investors.
How to calculate the return on invested capital?
Calculating ROIC requires us to divide profit by invested capital. The company’s capital comes from two main sources: debt and equity. In other words, ROIC is equal to net income divided by total debt plus total equity. Here is the ROIC formula:
- ROIC = Net profit / Average invested capital
Net income, or net profit, represents the revenue remaining after paying all expenses, including taxes to the government and interest to creditors. We can find it at the bottom of the income statement – and therefore, we also call it the bottom line.
Remember, net income is not the same as the money a company makes under accrual accounting. It includes non-cash items in the calculation, such as depreciation and amortization expenses.
Invested capital equals interest-bearing debt plus shareholder equity. Companies take interest-bearing debt from bank loans or from issuing debt securities. For the latter, it can be bonds or medium-term notes.
Debt has the consequence of regular payments, either as interest or coupons. Take bonds as an example. The company pays coupons regularly and principal at maturity. Failure to pay off debt can encourage creditors to file for bankruptcy against the company.
Meanwhile, equity represents ownership of the company. For example, companies sell their shares to the public through the stock exchange to raise funds. The three main equity components are common equity, preferred equity, and retained capital.
Then, if creditors earn interest as a return, shareholders earn dividends – if distributed – as a return. Another return is from capital gains when selling shares/bonds at a price higher than the purchase price.
The company distributes dividends from recorded net income. It may not be the entire profit, but only a certain percentage. And they keep the rest as internal capital (retained earnings). And, the accumulated retained earnings become part of equity on the balance sheet.
How to interpret the return on invested capital?
The higher the ROIC, the better. Because it shows how well it turns invested capital into profit, a high ratio indicates the company is making a high return for every money invested.
Stock investors like high ratios because they allow them to make more money. A high ROIC should drive the company’s share price up, allowing them to earn capital gains. In addition, they can get more dividends because the company generates high profits.
Meanwhile, creditors prefer companies with high ROIC because they can fulfill their obligations on time. When a company generates more profits, creditors expect the company to generate more cash inflows. Thus, the company should have a good ability to repay the loan.
On the other hand, a low ROIC is less desirable. This is because the company generates less profit for each invested capital. This may be due to the company’s uncompetitive market position and thus failing to maximize revenue. In addition, failure to manage operating costs efficiently can also be another cause.
What are the variations in calculating the return on invested capital?
The above equation is the basic formula. That tells, if we want to calculate ROIC, we have to compare profit with invested capital.
So, conceptually, the calculations are relatively easy. However, in practice, we may need adjustments to fit the context of our analysis.
So, the numbers we enter into the formula above may differ for net income and invested capital. The important thing is to justify why we use certain metrics over others. Then, if we compare ROIC between companies, the adjustment should be consistent for all companies.
For example, some people like net income as the numerator because it’s easier. Meanwhile, others may use other profit metrics, depending on their considerations, for example:
- Net profit minus dividend
- Earnings before interest and tax (EBIT)
- Net operating profit after tax (NOPAT)
Earnings before interest and tax (EBIT)
When using EBIT, we add back interest and tax expenses to net income. This metric is considered better to use when calculating ROIC because it reflects the company’s profit before it is distributed to creditors.
As explained earlier, interest expense represents a return to creditors. And when we use net income, we assume the company has paid it to creditors.
In fact, when calculating ROIC, we use total debt plus total equity as the denominator. In other words, net income should be just a return for shareholders, not for creditors (because they have already received interest payments).
Furthermore, EBIT excludes the tax burden to produce a more reasonable comparison. On the other hand, net income still includes taxes in the calculation. Thus, ROIC may vary between companies due to tax issues. In fact, taxes are beyond management’s control because they are determined by law.
For example, a company sells products to a low-tax country with less tax burden. Conversely, competitors may sell products to high-tax countries, leading them to report a higher tax burden. As a result, assuming their pretax earnings are exactly the same, the competitor will have a lower ROIC than the firm.
For such reasons, ROIC becomes less comparable when using net income. And it is better to use EBIT.
Net operating profit after tax (NOPAT)
NOPAT is another metric used as the numerator when calculating ROIC. Three reasons to use NOPAT.
First, NOPAT reflects the company’s success in generating profits from its core business. In the calculation, we exclude non-operating income or expenses.
Second, NOPAT is less volatile over time than net income. In contrast, net income is susceptible to significant spikes in non-operating income or expenses. For example, it can increase significantly when the company reports the proceeds from the sale of assets. As a result, the ROIC becomes less comparable because peers may not report such accounts.
In other cases, ROIC can increase when a company divests its subsidiary. Thus, competitors will tend to have lower ROIC than the company because they do not take similar corporate actions, even though their core business operations are better.
We calculate NOPAT by adjusting operating profit for taxes. Here is the formula:
- NOPAT = Operating profit x (1 – Tax rate)
Operating profit is equivalent to the revenue minus the cost of goods sold (HPP) and operating expenses (selling, general and administrative expenses). It also takes into account depreciation and amortization expenses.
Furthermore, we can also calculate NOPAT as net income plus interest expense after-tax. In this case, we often refer to it as earnings before interest after tax (EBIAT). However, the implications for ROIC will be similar to net income because we consider operating and non-operating results.
Invested capital
Invested capital equals total equity plus total interest-bearing debt. However, there are some variations in the calculations.
First, calculating total equity might exclude retained earnings because it represents internal capital, not shareholder contributions. Another variation excludes preferred stock and treasury stock in the equity calculation.
Second, total debt includes total long-term and short-term debt. However, some analysts may only use long-term debt. In addition, when companies do not have interest-bearing debt, they may use total liabilities to calculate total capital.
