Investors employ a variety of metrics to gauge the potential profitability of companies they consider investing in. These different metrics illuminate various facets of a company's financial performance, and when combined, they offer a comprehensive view of a company's financial health. In this article, we will delve into one such metric: Return on Capital (ROC), often referred to as Return on Invested Capital (ROIC). By the end of this piece, you will have a clear understanding of the ROIC formula, how it differs from other profitability metrics, and the core definition of return on invested capital.
What is Return on Capital (ROC) and Return on Invested Capital (ROIC)?
Return on Invested Capital (ROIC), also known as Return on Capital (ROC), serves as a measure of a company's efficiency in converting its capital raised through securities into profits. In simpler terms, ROIC indicates the percentage of profit a company produces from every invested dollar. Essentially, ROIC reveals what the company earns once average expenses, such as debt and equity capital, are settled. Typically represented as a percentage, this metric often denotes an annual figure, but sometimes it might reflect a trailing 12-month amount.
The ROIC Formula and Calculation
The formula for ROIC involves the relationship between the net operating profit after tax (NOPAT) and the invested capital. To assess if a company is deploying its capital effectively, you should juxtapose the ROIC value with the company's weighted average cost of capital (WACC). Historical observations suggest that a figure 2% above the company's capital cost is the threshold indicating that the business is generating value. Firms with a ROIC of zero on top of WACC essentially have no capital to expand.
ROIC is especially pertinent when analyzing companies that consistently invest in technological advancements and new equipment. While businesses less dependent on technology can also be assessed using ROIC, it might not be as significant a metric for them.
It's essential not to conflate return on capital with return of capital; the latter refers to a tax-free payment received from an investment.
What Can We Learn From ROIC?
When combined with the price-to-earnings (P/E) ratio, ROIC can offer invaluable insights into a company's performance. Sometimes, the P/E ratio might suggest that a company is oversold (undervalued), but a closer look at the ROIC can reveal that the actual reason for its decline is its decreased value generation for stakeholders. Conversely, a company with an unattractive P/E ratio can still be lucrative in terms of ROIC. However, it's always prudent not to rely solely on ROIC and to conduct a thorough evaluation of the company before committing any investment.
ROIC Formula and Calculation
The ROIC formula is quite simple. See it below:
ROIC stands for return of invested capital
NOPAT is net operating profit after tax
AIC means average invested capital
NOPAT is calculated using the following formula:
NOPAT = (operating profit) x (1 – effective tax rate)
Some might use an alternate formula where NOPAT is calculated as net income minus dividends. This method might not be as accurate since it doesn't account for profits from singular, non-recurring events.
To determine NOPAT, one often needs to extract two figures from the company's financial statement: the company's Earnings Before Interest and Taxes (EBIT) and its marginal tax rate. Locating the EBIT might be challenging, but it can be determined using other financial statement data. For instance, one could use the operating income combined with other income sources. Alternatively, one could find the earnings before interest, taxes, depreciation, and amortization (EBITDA) and then subtract both depreciation and amortization.
The final NOPAT computation would then be:
NOPAT = EBIT x (1 – tax rate)
Remember, tax rates differ by country, so ensure you're using the rate from the company's registered jurisdiction.
AIC, or the company's debt plus equity, can also be calculated as total assets minus cash and non-interest-bearing current liabilities. This includes liabilities like tax obligations and accounts payable, assuming they don't accrue interest or fees.
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In essence, invested capital represents the total funds a company accumulates through securities issuance, comprising the company's equity, borrowed resources, and capital lease commitments. Financial statements don't explicitly list invested capital, requiring investors to compute this by amalgamating all components of invested capital.
Limitations of ROIC
Let's delve into the limitations of ROIC. Firstly, ROIC provides an overview based on a company's entirety, even if the most significant value may be generated from just one of its many segments. For companies operating in multiple segments concurrently, ROIC might not offer a pinpointed evaluation.
Another drawback is ROIC's inefficiency in assessing financial institutions. Such companies inherently integrate capital within their products, leading the ROIC formula to potentially yield skewed results.
Furthermore, goodwill can distort ROIC-based valuations. A significant goodwill can result in an artificially low ROIC, primarily because it enlarges the denominator. If you're comparing multiple companies, and one relies heavily on capital leases, your comparison could be misleading. This is due to excess cash not being factored into the invested capital. Therefore, to get a more accurate picture, you might need to adjust the formula by excluding any surplus cash from a company's net working assets.
Example of How to Use ROIC
Consider a company that reported a Net Operating Profit After Tax (NOPAT) of $14 million. If its average investments over past years amounted to $280 million, the ROIC would be calculated as: (14 ÷ 280) x 100 = 5%. This indicates that for every $100 invested, the company generates a net profit of $5. We can’t conclude if 5% is a strong ROIC value. For a broader perspective, it would be prudent to compare this with competitors.
ROIC vs Other Financial Metrics
ROIC often complements metrics such as return on equity (ROE) and return on assets (ROA). What sets ROIC apart is its ability to offer a more nuanced analysis concerning a company's capital structure. It factors in both the investment amount and the returns on it, thus painting a clearer picture of a company's competence in deriving profits from invested capital. Additionally, ROIC is instrumental in gauging the long-term profit potential for shareholders.
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Another widely used metric in the returns category is the return on capital employed (ROCE). Similar to ROIC, ROCE evaluates how efficiently a company generates profits from its allocated capital. The formula for ROCE is: ROCE = NOPAT / CE, where CE represents the capital employed, calculated by subtracting current liabilities from total assets.
Return on invested capital stands out as a versatile metric. On one side, it indicates how adept a business is at generating shareholder profits from its invested capital. On the flip side, when aligned with historical data, ROIC can assist in projecting a company's future financing and investment strategies.
In the realm of competitive analysis, ROIC is deemed a robust metric. Companies boasting a higher ROIC often command favorable trading positions. However, for a fair comparison, it's essential to make adjustments to some metrics in the calculations.