Return on Invested Capital (ROIC) corrects the shortfall of ROE. ROE can understate the amount of resources that a company has at its disposal. It can overstate the company’s return on capital. An investor may misjudge a business’ performance. ROIC looks at all the money invested into the company, both by shareholders and lenders, and how well management uses all the cash to generate profits. ROICs are useful for evaluating companies within sectors. The companies with the highest ROICs are making more profits out of every dollar invested.
ROIC = EBIT / Invested Capital where EBIT = Earnings Before Interest and Tax or Operating Profit
ROIC measures the return generated on all capital, from interest-bearing debts as well as equity, invested in a company. It has to consider earnings not just to equity investors but also to lenders in the form of interest payments. EBIT is revenue from revenue of goods and services it provides, less its operating expenses, and depreciation of its core business activities is used. EBIT excludes income outside its core operations such as other investments, taxes, interest expenses, and other nonrecurring items. EBIT is adjusted for tax as Net Operating Profit after Tax, or NOPAT = EBIT x (1 – Tax Rate) where Tax Rate = Tax Expense/ Profit Before Tax.
Invested Capital is the total amount of money that was endowed into a company by the shareholders, debtholders, and all other interested parties and used in the ordinary business activities of the company. IC in the capital approach is determined by adding the total debt to the amount of equity in the firm and then subtracting the non-operating cash and investment.
IC = Total Equity + Total Debt – Excess cash and other investments
We net out excess cash and investments to be consistent with the use of operating income as our measure of earnings. excess cash can be defined as the cash of a company has that is not required to operate the core business.
Another intuitive way is to view IC from the operating approach, capital used for the core operations which includes the net working capital (NWC) plus the fixed assets required
Net Working Capital = Inventories + Receivables – Payables
Fixed Assets = Property Plant and Equipment (PPE) + Prepaid Expenses + Lease Payment
IC = Net Working Capital + Fixed Assets
For property companies of which the rental income from the investment properties is part of their ordinary or core income, investment properties should also be considered as part of their IC. The reason we subtract payable from IC is because it represents capital invested in the business by a company’s suppliers or contractors, not the company itself.
ROIC (before tax) = EBIT/IC = 108.8 / 261.48 = 41.6%
ROIC (after-tax) = NOPAT/IC = 83.6 / 261.48 = 32.0%
For a company with a lot of excess cash, ROIC will be higher than ROE. For a company with a low profit margin, asset turnover, and heavy debt its ROIC will be low, way below its cost of capital as well as ROE, this is destroying your investment!
Category 1 High ROIC with low capital requirement
Long-term competitive advantage in a stable industry is what we look for in a business. If that comes with rapid organic growth, that is great. Think about return on capital to know how much capital a business requires, how much of its earnings it can retain and reinvest, and what the returns from those investments will look like going forward.
Category 2 Businesses that require capital to grow to produce adequate returns on capital
Typically companies that increase their earnings from $5 million to $82 million require, say $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.
A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is to follow our earlier example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. That equation for the owner is different from the Category 1. It’s far better to have an ever-increasing stream of earnings with no major capital requirements. If measured by economic returns, this type of business is excellent but not extraordinary business. This type of business is putting up more money to earn more. We will earn more money in this business ten years from now but we will need to invest many billions to make it.
Category 3 – Businesses that require capital but generate low returns
The worst sort of business is one that grows rapidly, requires significant capital to engender growth, and then earns little or no money. Think airlines. The airline industry’s demand for capital ever since the first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.
To sum it up, think of three types of “savings accounts”. The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.
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