Return on Invested Capital (ROIC)

What it is:

Return on invested capital (ROIC) is a profitability ratio. It measures the return that an investment generates for those who have provided capital, i.e. bondholders and stockholders.  ROIC tells us how good a company is at turning capital into profits.

How it works/Example:

The general equation for ROIC is:  ( Net income - Dividends ) / ( Debt + Equity )

ROIC can also be known as "return on capital" or "return on total capital."

For example, Manufacturing Company MM lists $100,000 as net income, $500,000 in total debt and $100,000 in shareholder equity. Its business operations are straightforward -- MM makes and sells widgets.

We can calculate MM's ROIC with the equation:

ROIC = ( Net income - Dividends ) / ( Debt + Equity )

         = (100,000 - 0) / (500,000 + 100,000) = 16.7%

Note that for some companies, net income may not be the profitability measure you want to use. You want to make sure that the profit metric you put in the numerator is giving you the information you need.

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ROIC is most useful when you're using it to calculate the returns generated by the business operation itself, not the ephemeral results from one-time events. Gains/losses from foreign currency fluctuations and other one-time events contribute to the net income listed on the bottom line, but they're not really recurring results from business operations. Try to think of what your business "does" and only consider income related to that core business.

For example, Conglomerate CC lists $100,000 as net income, $500,000 in total debt and $100,000 in shareholder equity. But when you look at CC's income statement, you notice a lot of extra line-items, like "gains from foreign currency transactions" and "gains from one-time transactions."

In the case of CC, if you use the net income number, you can't be very specific as to where the returns are being generated. Were they from strong business results? Were they from fluctuations in the foreign currency markets? Did CC sell a subsidiary?

For CC, it would make more sense to use an income measure called net operating profits after tax (NOPAT) as the numerator. It's not found on the income statement, but you can derive it yourself with the following equation:

NOPAT = Earnings Before Interest & Taxes * (1 - Tax Rate)

Using NOPAT in the equation will tell you the return the company generated with its core business operations for both its bondholders and stockholders.

Why it Matters:

A firm's ROIC can be an excellent indicator of the size and strength of its moat. If a company is able to generate ROIC of 15-20% year after year, it has developed a great method for turning investor capital into profits.

ROIC is especially useful for companies that invest a large amount of capital, like oil and gas firms, computer hardware companies, and even big box stores. As an investor, it's important to know that if a company takes your money, you'll get an adequate return on your investment.

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