What it means
Average returns on capital can hide what is happening at the edge. A company might earn 20% on its old assets but only 6% on its new projects, and the headline figure would hide that decline.
RONIC isolates the new money, so you can see whether fresh investment is actually adding value. The measure sits at the heart of the value driver approach to valuation, which links growth and returns.
Growth only creates value if the return on new capital exceeds the cost of that capital. If RONIC equals the cost of capital, growth adds nothing, and if it is below, growth destroys value.
To calculate RONIC, you compare the increase in operating profit after tax, known as NOPAT, with the new capital invested. Timing matters, because investments usually take time to show results, so analysts often compare this year's profit change with last year's investment.
The numbers can be noisy, so it is wise to use several years. Analysts use RONIC when they build a long-term forecast of a company's value.
In a discounted cash flow model, the free cash flow depends on how much profit growth the company wants and how much capital it must reinvest to get that growth. A higher RONIC means less reinvestment is needed for each unit of growth.
Managers can use the measure too. If a business unit can show that its RONIC is well above the cost of capital, it makes a strong case for more funding.
If RONIC is low, the unit should be asked whether the growth it wants is worth buying. The nuance is that RONIC is hard to measure cleanly.
New profit may come from price rises or cost cuts rather than from the new capital, and acquisitions muddy the picture. In long-run forecasts, many analysts assume RONIC will fall towards the cost of capital as competition erodes excess returns.
In practice
Real-world examples.
Example
A logistics company adds a second warehouse for $12,000,000 and, two years later, sees operating profit after tax rise by $1,500,000. RONIC is 1,500,000 / 12,000,000 = 12.5%. The board compares this with a cost of capital of 9% and approves a third warehouse.
Example
An analyst values a software company by forecasting growth of 6% a year. She assumes RONIC of 20% at first and then lets it fade towards the cost of capital over ten years. This stops her model from assuming that excess returns last forever.
Example
A hotel group spends $30,000,000 on refurbishment and sees profit after tax rise by only $1,200,000. RONIC is 4%, below its cost of capital of 8%. The finance director concludes that the refurbishment protected the brand but did not create financial value.
Formula
Calculation
RONIC = Change in NOPAT / New invested capital
Suppose a manufacturer's NOPAT rises from $5,000,000 to $5,900,000 after it invests $6,000,000 in new capacity. The change in NOPAT is 5,900,000 - 5,000,000 = $900,000. RONIC = 900,000 / 6,000,000 = 0.15, or 15%. If the cost of capital is 9%, the new investment earned 6 percentage points above its cost.Case study
Seen in the real world.
Aldermoor Retail is an illustrative, fictional chain that grew quickly by opening new stores. Its overall return on invested capital looked healthy at 14%, so the board saw no reason to slow expansion.
An analyst calculated RONIC for the last three years. The company had invested $45,000,000 in new stores, but NOPAT had grown by only $2,700,000, giving a RONIC of 2,700,000 / 45,000,000 = 6%.
With a cost of capital of 9%, the new stores were destroying value even though the overall figure looked fine. The illustrative lesson is that RONIC reveals what an average return hides. The board asked management to set a minimum RONIC hurdle for every new store proposal, based on the cost of capital plus a margin for risk. Proposals that could not clear the hurdle on realistic sales forecasts were deferred until the economics improved.
Watch out
Common mistakes.
- Using the overall return on capital to judge growth, which blends old strong assets with new weaker ones.
- Counting profit growth that came from price rises or cost cuts as if it were produced by the new capital.
- Assuming a high RONIC will last forever, when competition usually erodes excess returns over time.
Questions
People also ask.
What is a good RONIC?
One that is clearly above the cost of capital, because only then does new investment create value for owners.
How is RONIC different from ROIC?
ROIC looks at all capital employed, while RONIC looks only at the extra capital added and the extra profit it produced.
Why do valuation models use RONIC?
It links growth to the reinvestment needed to achieve it, so a model cannot assume fast growth without the cash required to fund it.
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