A popular financial parameter, Return on Invested capital (ROIC) is a profitability ratio that measures the percentage return an investor is earning from its invested capital (in other words, return on capital); and it is determined by dividing the company’s net operating profit on an after-tax basis by its invested capital.
Many times when investors face dilemma on whether they should make an investment in a business or not, they turn to ROIC ratio to know whether the investment will make value for them or not.
The formula for ROIC is – (Net income – Dividends) / Total Capital (Debt + Equity) or Net Operating Profit After Tax (NOPAT)/Invested Capital = ROIC.
To be able to calculate the ROIC, one needs to know the value of total capital first. The total capital of the company is calculated by adding the total debt and total equity of the company. Another important thing which is needed to calculate ROIC is through NOPAT. Net Operating Profit After Tax (NOPAT) is calculated by subtracting taxes from operating profit.
To know whether the company is creating value or not, the ROIC ratio of the company is compared with Cost of Capital. Cost of capital, required rate of return which is necessary to make a Capital Budgeting project, is an important component of business valuation as investors generally expect their investments to grow by at least the cost of capital.
The most common cost of capital metric is weighted average cost of capital (WACC) and generally ROICs are compared with WACC to know whether the business is creating value for the investors or not. If a company’s ROIC is higher than WACC it means that company is creating value and if the ROIC is lower than WACC it means that the company is not creating value.
For example, if a Company is having a ROIC of 10% and WACC of 7%, it means that the company is maximizing its invested capital, and, in this case, investor should hold or buy the stock of the company.
In a different case if the company is having a ROIC of 12% and WACC is 17% then it means that the company is not maximizing its invested capital and, in this case, need to move their money elsewhere to higher-performing opportunities. ROIC can also be a useful tool in determining a Company’s Competitiveness.
Generally, companies which are having higher ROICs are considered more valuable, however it is very important to understand that return on Invested Capital (ROIC) by itself doesn’t tell much about a company’s competitive advantage in the market. Besides calculating ROIC, an investor should also calculate other profitability ratios like profit margin, return on assets (ROA) and return on equity (ROE) before taking an investment decision.
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