A popular financial parameter, Return on Invested capitalÂ (ROIC) is a profitability ratio that measures the percentage return an investor is earning from its investedÂ 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 incomeÂ - Dividends) / Total Capital (DebtÂ +Â Equity)Â or NetÂ Operating ProfitÂ After Tax (NOPAT)/InvestedÂ CapitalÂ =Â 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. NetÂ Operating ProfitÂ 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 theirÂ investmentsÂ 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. Â If a companyâs 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-performingÂ opportunities. ROIC can also be a useful tool in determining a Companyâs 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 doesnât tell much about a companyâs competitive advantage in the market. Besides calculating ROIC, an investor should also calculate other profitability ratios like profit margin, return on assets (ROA) andÂ return on equityÂ (ROE) before taking an investment decision.
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