Find Quality Investments With ROIC

Return on invested capital, or ROIC, is arguably one of the most reliable performance metrics for spotting quality investments. But in spite of its importance, the metric doesn’t get the same level of interest and exposure as indicators like the P/E or ROE ratios.

Admittedly, investors can’t just pull the return on invested capital straight off a financial document like they can with better-known performance ratios; calculating ROIC requires a bit more work. But for those eager to learn just how much profit and, hence, true value a company is producing, calculating the ROIC is well worth the effort.

Important mainly for assessing companies in industries that invest a large amount of capital—such as oil and gas players, semiconductor chip companies, and even food giants—ROIC is a telling gauge for comparing the relative profitability levels of companies. For many industrial sectors, ROIC is the preferred benchmark for comparing performance. In fact, if investors were forced to rely on a sole ratio (which we do not recommend), they would be best off choosing ROIC.

ROIC Calculations

Defined as the cash rate of return on capital that a company has invested, ROIC shows how much cash is going out of a business in relation to how much is coming in. In a nutshell, ROIC is the measure of cash-on-cash yield and the effectiveness of the company’s employment of capital. The formula looks like this:

ROIC = Net Operating Profits After Tax (NOPAT) / Invested Capital

At first glance, the formula looks simple. But in the complex financial statements published by companies, generating an accurate number from the formula can be trickier than it appears. To keep things simple, start with invested capital, the formula’s denominator. Representing all the cash that investors have put into the company, invested capital is derived from the assets and liabilities portions of the balance sheet as follows:

Invested Capital = Total Assets less Cash – Short-Term Investments – Long-Term Investments – Non-Interest Bearing Current Liabilities

Now, investors turn to the income statement to determine the numerator, which is after-tax operating profits, or NOPAT. Sometimes NOPAT is the same as net income. For many companies, especially bigger ones, some net income comes from outside investments, in which case net income does not reflect the profitability of operating activities. Reported net income needs to be adjusted to represent operations more accurately.

At the same time, the published net income figure also may include non-cash items that need to be added and subtracted from NOPAT to reflect true cash yield. For the purpose of showing all of a company’s cash profits from the capital it invests, NOPAT is calculated as the following:

NOPAT = Reported Net Income – Investment and Interest Income – Tax Shield from Interest Expenses (effective tax rate x interest expense) + Goodwill Amortization + Non-Recurring Costs plus Interest Expenses + Tax Paid on Investments and Interest Income (effective tax rate x investment income)

Interpreting ROIC

If the final ROIC figure, which is expressed as a percentage, is greater than the company’s working asset cost of capital, or WACC, the company is creating value for investors. The WACC represents the minimum rate of return (risk-adjusted) at which a company produces value for its investors.

Let’s say a company produces a ROIC of 20% and has a cost of capital of 11%. That means the company has created nine cents of value for every dollar that it invests in capital. By contrast, if ROIC is less than WACC, the company is eroding value, and investors should be putting their money elsewhere.

The extent to which ROIC exceeds WACC provides an extremely powerful tool for choosing investments. The P/E ratio, on the other hand, does not tell investors whether the company is producing value or how much capital the company consumes to produce its earnings. ROIC, by contrast, provides all this valuable information and more.

Investors should look not only at the level of ROIC but also the trend. A falling ROIC can provide an early warning sign of a company’s difficulty in choosing investment opportunities or coping with competitors. ROIC that is going up, meanwhile, strongly indicates that a company is pulling ahead of competitors or that its managers are more effectively allocating capital investments.

The Bottom Line

ROIC is a highly reliable instrument for measuring investment quality. It takes a bit of work, but, once investors start figuring out ROIC, they can begin to track company results annually and be better armed to spot quality companies before everyone else does.