How Return on Invested Capital Is Calculated
When making an investment in a business, whether as a principal of a small company or as a stockholder in an international corporation, investors want to be able to quantify the annual return on their investment to see if they need to move their dollars elsewhere to higher-performing opportunities.
Return on Invested Capital (ROIC) is a profitability or performance ratio that measures how much investors in a business are earning on the capital invested. When used in financial analysis, return on invested capital also offers a useful valuation measure.
Stock Market Average Return
The stock market, for example, has returned about 7 percent annually on average over the past 100 years, after adjusting for inflation and dividend payments.
Used as a benchmark, if you're consistently getting a return of 5 to 7 percent after inflation, that's not at all bad. If, on the other hand, your return on investment barely beats inflation or even falls below the inflation rate, your return falls into the less-than-satisfactory category.
The Return on Invested Capital Calculation
To calculate a company's ROIC, divide the company's net operating profit on an after-tax basis by its operating capital. However, you won't find the numerator and denominator of this equation on a company's financial statements. You'll need to calculate them first.
To calculate the numerator, Net Operating Profit after Taxes (NOPAT), start with the income statement. You will see revenues, expenses, and the difference between them, typically labeled as operating income. To this number, add back any charges made for depreciation and amortization, to arrive at the company's Earnings Before Interest and Taxes (EBIT).
Apply taxes to EBIT by multiplying the figure by (1-tax rate) to arrive at NOPAT. If desired, you also can leave out the tax effects and use EBIT as the numerator.
The denominator in the ROIC formula is operating capital. The company's balance sheet shows all of the accounts that make up the firm's capital. In general, operating capital includes debt in the form of notes payable and long-term bonds, with equity in the form of common and preferred stock.
For simplicity, the following example assumes a simple balance sheet that has only long-term debt (notes payable) and common stock equity accounts.
Calculate operating capital, the denominator, by adding the company's average debt-related liabilities to its average stockholders' equity. Do not include non-interest-bearing liabilities such as prepaid insurance or unearned revenue. Calculate the numerator and denominator as follows:
- Numerator: NOPAT = Operating Income * (1 - Tax Rate)
- Denominator: Operating Capital = Average Debt Liabilities + Average Stockholders' Equity
Plug these inputs into the ROIC formula to solve the formula for Return on Invested Capital:
- ROIC = NOPAT / Operating Capital
Interpreting the ROIC
A company's ROIC provides a measure of performance, indicating how much return it generates with each dollar of operating capital. If the firm's ROIC is greater than its weighted average cost of capital (WACC), then the business is adding value by maximizing its use of debt and equity capital.
While calculating a company's weighted average cost of capital (WACC) isn't difficult, it does require the gathering of several pieces of data to perform the calculation. Instead, you can easily find a public company's WACC through any major brokerage, including most of the online brokerages.
Once you obtain a given company's WACC, you can use it as a decision-making tool. Suppose, for instance, that a company has a 15-percent ROIC and a WACC of 8 percent. This means that the company returns a net 7 percent to its investors.
Depending on the general economic environment, this could be good or bad; it's likely somewhere in the middle. If, on the other hand, the company has an ROIC of 8 percent and a WACC of 9 percent, it's not maximizing its invested capital, and you would be wise to hold off on buying the company's stock.