Return on Invested Capital: What Is It, Formula and Calculation, and Example (2024)

What Is Return on Invested Capital (ROIC)?

Return on invested capital (ROIC) assesses a company's efficiency in allocating capital to profitable investments. It is calculated by dividing net operating profit after tax (NOPAT) by invested capital.

ROIC gives a sense of how well a company is using its capital to generate profits. Comparing a company's ROIC with its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.

ROIC Formula and Calculation

The formula for ROIC is:

$\begin{aligned} &\text{ROIC} = \frac{ \text{NOPAT} }{ \text{Invested Capital} } \\ &\textbf{where:}\\ &\text{NOPAT} = \text{Net operating profit after tax} \\ \end{aligned}$​ROIC=InvestedCapitalNOPAT​where:NOPAT=Netoperatingprofitaftertax​

Written another way, ROIC = (net income – dividends) / (debt + equity). The ROIC formula is calculated by assessing the value in the denominator, total capital, which is the sum of a company's debt and equity.

There are several ways to calculate this value. One is to subtract cash and non-interest-bearing current liabilities (NIBCL)—including tax liabilities and accounts payable, as long as these are not subject to interest or fees—from total assets.

Another method of calculating invested capital is to add the book value of a company's equity to the book value of its debt and then subtract non-operating assets, including cash and cash equivalents, marketable securities, and assets of discontinued operations.

A final way to calculate invested capital is to obtain the working capital figure by subtracting current liabilities from current assets. Next, you obtain non-cash working capital by subtracting cash from the working capital value you just calculated. Finally, non-cash working capital is added to a company's fixed assets.

The value in the numerator can also be calculated in several ways. The most straightforward way is to subtract dividends from a company's net income.

On the other hand, because a company may have benefited from a one-time source of income unrelated to its core business—a windfall from foreign exchange rate fluctuations, for example—it is often preferable to look at net operating profit after taxes (NOPAT). NOPAT is calculated by adjusting the operating profit for taxes:

NOPAT = (operating profit) x (1 – effective tax rate)

Example of ROIC

Target Corporation (TGT) calculates its ROIC directly in its 10-K, showing the components that went into the calculation:

The ROIC calculation begins with operating income, then adds nets other income to get EBIT. Operating lease interest is then added back and income taxes subtracted to get NOPAT. Target's invested capital includes shareholder equity, long-term debt, and operating lease liabilities. Target subtracts cash and cash equivalents from the sum of those figures to get its invested capital.

What ROIC Can Tell You

ROIC is always calculated as a percentage and is usually expressed as an annualized or trailing 12-month value. It should be compared to a company's cost of capital to determine whether the company is creating value.

If ROIC is greater than a firm's weighted average cost of capital (WACC)—the most commonly used cost of capital metric—value is being created and these firms will trade at a premium. A common benchmark for evidence of value creation is a return of two percentage points above the firm's cost of capital.

Some firms run at a zero-return level, and while they may not be destroying value, these companies have no excess capital to invest in future growth.

To get a better idea of what a decent or acceptable ROIC is, you can compare companies operating in the same sector. If a company consistently delivers higher ROIC than its peer group, it generally means it is better run and more profitable. In the case of mature, established companies, comparing current ROIC to past ROIC can also be useful.

ROIC Works Well Alongside Valuation Metrics

ROIC provides the necessary context for other metrics such as the price-to-earnings (P/E) ratio. Viewed in isolation, the P/E ratio might suggest a company is oversold, but the decline could be because the company is no longer generating value for shareholders at the same rate (or at all). On the other hand, companies that consistently generate high rates of return on capital invested probably deserve to trade at a premium compared to other stocks.

Limitations of ROIC

ROIC is one of the most important and informative valuation metrics to calculate. However, it is more important for some sectors than others. Some companies, such as those that operate oil rigs or manufacture semiconductors, invest capital much more intensively than those that require less equipment.

A major downside of this metric is that it tells nothing about what segment of the business is generating value. If you make your calculation based on net income (minus dividends) instead of NOPAT, the result can be even more opaque, since the return may derive from a single, non-recurring event.

The Bottom Line

ROIC is a popular financial metric. It tells us how well a company uses its capital and whether it is creating value with its investments. At a minimum, a company’s ROIC should be higher than its cost of capital. If it consistently isn’t, the business model is not sustainable.

ROIC is particularly useful when examining companies that invest a large amount of capital. Moreover, like many metrics, it is more informative when used to compare similar companies operating in the same sector. Often, the companies in a sector with the highest ROICs will trade at a premium.