What it means
Every business is funded by a mix of shareholders' equity and borrowing. ROIC looks at all of that funding together and asks a simple question: how much profit did the operations generate from it.
Because it uses operating profit, the result is not distorted by whether the firm chose to fund itself with debt or equity. The numerator is net operating profit after tax, often shortened to NOPAT.
You find it by taking operating profit (earnings before interest and tax) and deducting the tax that would be paid on it. The denominator is invested capital, which is usually debt plus equity less any surplus cash.
Investors and managers use ROIC to judge the quality of a business. A company with a high ROIC can grow by reinvesting its profits at attractive returns, whereas a company with a low ROIC may be destroying value even when its profits are rising.
The comparison point is the weighted average cost of capital, which is the blended cost of the firm's debt and equity. Different analysts calculate invested capital in slightly different ways, so figures from different sources may not match.
Some use average capital over the year and others use the opening balance, and treatments of leases and goodwill (the premium paid when buying a business) vary. When comparing companies, use one method for all of them.
ROIC is most useful when tracked over time and against competitors in the same industry. A steady or rising figure points to a durable advantage, while a falling one may signal growing competition or poor capital spending.
Single-year jumps deserve scrutiny, since one-off items can distort the profit figure. Managers can also use ROIC to compare projects and divisions inside a group.
A division that earns less than the cost of capital year after year is consuming value, and the question becomes whether to fix it, shrink it or sell it.
In practice
Real-world examples.
Example
A food manufacturer reports operating profit of $9,000,000 on invested capital of $60,000,000 with a 20% tax rate. Its NOPAT is $7,200,000 and ROIC is 12%, which the board compares with a cost of capital of 8%.
Example
A software company with few physical assets earns NOPAT of $30,000,000 on invested capital of $50,000,000. Its ROIC of 60% shows that growth needs little capital, so most of the profit can be paid out or reinvested in new products.
Example
A shipping business invests heavily in new vessels, and ROIC falls from 11% to 6% in two years. The chief financial officer shows the board that the new ships are earning less than the cost of the money used to buy them.
Formula
Calculation
ROIC = NOPAT / Invested capital
NOPAT = Operating profit x (1 - Tax rate)
Suppose a company has operating profit of $20,000,000 and a tax rate of 25%. NOPAT is $20,000,000 x (1 - 0.25) = $15,000,000. If invested capital is $100,000,000, then ROIC is $15,000,000 / $100,000,000 = 0.15, or 15%. If the company's cost of capital is 9%, it earns 6 percentage points above its cost of funds.Case study
Seen in the real world.
Valehaven Industries is an illustrative, fictional manufacturer that was proud of rising profits in each of the last four years. The new finance director asked for ROIC as well, and the board was surprised to find that it had slipped from 14% to 8%.
The explanation was that the company had bought three smaller businesses at high prices, adding a great deal of capital while the extra profit was modest. With a cost of capital near 9%, the acquisitions were earning less than they cost to finance.
In this fictional case the board adopted a rule that every acquisition must forecast a ROIC above the cost of capital within three years. Managers were also asked to report ROIC each quarter alongside profit, so any slide would be noticed early. The illustrative lesson is that growing profit is not the same as creating value, and ROIC exposes the difference.
Watch out
Common mistakes.
- Using net income instead of operating profit after tax, which mixes financing choices into an operating measure.
- Comparing ROIC with nothing, when the figure only has meaning against the cost of capital.
- Calculating invested capital differently from year to year, which makes trends unreliable.
Questions
People also ask.
How is ROIC different from return on equity?
ROIC covers all capital, both debt and equity, and uses operating profit, whereas return on equity looks only at shareholders' funds and net income.
What is a good ROIC?
A good figure is one comfortably above the company's cost of capital, and the level that counts as strong varies by industry.
Why is tax deducted in ROIC?
Because tax is a real cost of earning the profit, and using after-tax figures lets you compare the return with the after-tax cost of capital.
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