Calculating Return on Invested Capital
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 determine whether it is worth continuing to invest.
Return on Invested Capital (ROIC) is a profitability or performance ratio that measures how much investors are earning on the capital invested. When used in financial analysis, return on invested capital also offers a useful valuation measure.
Elements of the ROIC Formula
To calculate a company's ROIC, you'll need to reference your company's financial statements and records. The elements you need are:
Net Operating Profit After Taxes (NOPAT). NOPAT is a representation of the income a company would have if there were no taxes. This is not a standard measurement, as it is not a line item on financial reporting statements.
The information you need can be taken from your income statement. You'll need your net income, taxes, interest, and non-operating income. NOPAT is calculated as:
(Net Income + Tax + Interest + Non - Operating Gains or Losses) x (1 - Tax Rate)
You can also use Earnings Before Interest and Taxes (EBIT) to calculate NOPAT:
EBIT = Net profit - Interest Expenses - Income Tax Expense
EBIT x (1 - Tax Rate) = NOPAT
It will vary greatly between companies that have different cost structures.
Invested capital is the amount investors have contributed to the company for funding by purchasing shares. Invested capital is not an item on any of your financial statements. You'll need to collect it from accounting records such as your journals and ledgers, which are standard accounting tools.
Calculating the ROIC
The formula you'll need to use is:
ROIC = Net Operating Profit After Taxes ÷ Invested 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.
Generally, a company which has an ROIC of 2% or greater is generating value for investors. If your company has an ROIC of 1.9% or less, investors will tend to steer clear unless other assurances can be provided, such as future plans that have potential.
The return on invested capital is useful for comparing to the weighted average cost of capital (WACC). The WACC is also known as the cost of capital.
A comparison of the two demonstrates value added or lost for a period. If the firm's ROIC is greater than its WACC, then the business is adding value by maximizing its use of debt and equity capital. If it is less, then it is not adding value.
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% ROIC and a WACC of 8%. This means that the company returns 7% to its investors.
A company may have an ROIC of 8 percent and a WACC of 9 percent, which is generally considered to not be maximizing invested capital.
Either comparison could be a good indicator or a bad one. It depends on the amount of risk an investor is willing to assume, industry averages, or past performance of a company.