Return on Invested Capital – ROIC Definition

Return on invested capital is a calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments.

The return on invested capital ratio gives a sense of how well a company is using its money to generate returns. Comparing a company's return on invested capital with its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively. This measure is also known simply as "return on capital."

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

Calculating return on invested capital starts with assessing the value in the denominator, total capital, which is the sum of a company's debt and equity. There are a number of 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, then subtract non-operating assets, including cash and cash equivalents, marketable securities, and assets of discontinued operations.

Yet another way to calculate invested capital is to obtain working capital 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, also known as long-term or non-current assets.

The value in the numerator can also be calculated in a number of 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: (operating profit) * (1 - effective tax rate). Operating profit is also referred to as earnings before interest and tax (EBIT). Many companies will report their effective tax rates for the quarter or fiscal year in their earnings releases, but not all.

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 common 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 in excess of 2% of the firm's cost of capital.

If a company's ROIC is less than 2%, it is considered a value destroyer. 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.

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

In Target Corp.'s (TGT) fourth-quarter 2017 earnings release, the company calculates its trailing 12-month month ROIC, showing the components that go into the calculation:

It begins with earnings from continuing operations before interest expense and income taxes, adds operating lease interest, then subtracts income taxes, yielding a net profit after taxes of $3,528 m: this is the numerator. Next, it adds the current portion of long-term debt and other borrowings, the non-current portion of long-term debt, shareholders equity and capitalized operating lease obligations.

It then subtracts cash and cash equivalents and net assets of discontinued operations, yielding invested capital of $22,152 m. Averaging this with the invested capital from the end of the prior-year period ($22,315 m), you end up with a denominator of $22,152 m. The resulting after-tax return on invested capital is 15.9%. The company attributed the increase over the previous 12 months largely to the effects of the tax bill passed in late 2017.

This calculation would have been difficult to obtain from the income statement and balance sheet alone since the asterisked values are buried in an addendum. For this reason, calculating ROIC can be tricky, but it is worth arriving at a ballpark figure in order to assess a company's efficiency at putting capital to work.

One 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 it is possible that the return derives from a single, non-recurring event.

ROIC provides the necessary context for other metrics such as the P/E ratio. Viewed in isolation, the P/E ratio might suggest a company is oversold, but the decline could be due to the fact that 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 invested capital probably deserve to trade at a premium to other stocks, even if their P/E ratios seem prohibitively high.