Return On Invested Capital (ROIC)

Why should I care about ROIC?

For markets: Investors use ROIC to assess the quality of a company's ability to generate returns that exceed its cost of capital. A consistently high ROIC suggests that a company is effectively converting invested capital into profits, which reflects positively on its management and bodes well for its competitive position within its industry.

Zooming in: Investors often weigh a company's ROIC against its cost of borrowing money from debt or bondholders and from shareholders. That’s typically measured as a weighted average cost of capital (WACC) and is used to assess whether a company is creating value for its investors (ROIC is greater than WACC) or destroying value (WACC is greater than ROIC).

The bigger picture: Some investors analyze ROIC across countries and industries, looking for insights into where to find the most efficient place to invest their cash. In other words, where their invested capital will generate the greatest return.

How is ROIC calculated?

Calculated by dividing the net operating profit after tax (NOPAT) by the total invested capital, the ROIC is often expressed as a percentage.

• NOPAT is a measure of after-tax earnings assuming no debt as it doesn’t take interest costs into account
• Invested capital represents the money put into a company by shareholders and debt holders

ROIC calculation example

1. Calculate NOPAT

2. Calculate invested capital

For a closer reflection of the company’s financial reality, you may want to calculate invested capital based on the average equity, debt, and cash over a financial period rather than take a single, point-in-time, figure from the end of the period.

3. Calculate ROIC

What is a good ROIC ratio?

A “good” ROIC shows a company can consistently generate returns well above its cost of capital, creating substantial value for its shareholders. Returns on invested capital vary depending on industry characteristics, and a given company's business model, and may fluctuate based on the economic environment. At a minimum, a good ROIC exceeds the company's weighted average cost of capital (WACC), which represents the minimum return necessary to satisfy shareholders and creditors. The average ROIC for S&P 500 companies is 11.8%.

A company’s ROIC should be analyzed in the context of its history and the returns of peers in its industry given that different sectors have different capital requirements and profit potentials. For instance, software companies tend to have higher ROICs as they need to spend less on things like machinery and buildings. On the other hand, so-called “capital-intensive” industries such as utilities or manufacturing – which require large amounts of cash to spend on plants, property, and machinery – will show lower ROICs.

In mature sectors, ROIC that is higher than the industry over a long time suggests a company has a durable competitive advantage. Companies in high-growth phases of their development or high-growth industries may choose to reinvest earnings in a way that lowers ROIC. Therefore, a company’s growth outlook should also be considered when evaluating ROIC.

What’s the relationship between ROIC and WACC?

Business owners, investors, and financial analysts alike often compare a company's ROIC to its WACC to understand whether it’s creating or destroying value for investors.

• Value creation (ROIC > WACC): When a company's ROIC exceeds its WACC, it indicates that the company is generating a return on investments higher than its cost of capital. As a rule of thumb, investors might take a ROIC two percentage points higher (+2%) than the company's WACC as indicative of efficient use of capital. Investors might reasonably conclude that investing in that company may yield positive fundamental returns.
• Value destruction (ROIC < WACC): When a company’s ROIC is less than its WACC, the company is earning less from its use of investors’ money than it costs to pay investors for that cash in the first place. That suggests the company is using investors’ money inefficiently. Such companies, then, might need to rethink their plans and consider returning capital to shareholders rather than reinvesting it internally.

What are the limitations of ROIC?

ROIC, while a valuable metric, has limitations that can impact its accuracy and relevance:

• Industry variability: Different industries or business models within them have inherently different cost structures and capital intensities, which can skew comparisons without appropriate industry-specific benchmarks. In other words, it may make sense to compare the returns of businesses in the same industry and that work in similar ways, but it’s a less useful way to compare businesses in different industries.
• Business segmentation: Companies with multiple business units or diverse industry operations can drive ROIC figures that obscure which parts of the business are driving value creation. That’s because, while companies often split out profits by business units, invested capital is grouped for the company overall.
• Accounting practices and non-recurring items: Changes in accounting methods can affect NOPAT, making it a less reliable metric, while how companies treat capital leases and excess cash can affect invested capital calculations. Similarly, one-off costs like restructuring can distort profit in a given period. Expert analysts tend to “adjust” their figures to remove these distortions otherwise it can prove a limitation in analyzing returns. Different accounting methods can manipulate ROIC, as management may select practices that favorably influence the metric, potentially distorting financial health portrayal.
• Goodwill: Large amounts of goodwill on a company’s balance sheet will lower ROIC, potentially limiting its comparability. Investors, then, may choose to exclude goodwill from their calculations.

What’s the difference between ROIC, ROCE, ROE, and ROA?

Comparison of returns metrics

Frequently Asked Questions (FAQs)

Is a 50% ROIC good?

A 50% ROIC is high. It indicates that the company is generating 50 cents in profit for every dollar of capital invested – a very efficient use of invested capital given the S&P 500 average of 18%. Over the last 20 years, Apple’s average ROIC is close to 50%.

Should ROIC be higher than WACC?

Yes, an ROIC higher than WACC indicates that a company is creating value – generating returns that exceed its cost of capital.

Can ROIC be negative?

ROIC can be negative if, for instance, a company generates operating losses, leading to a negative NOPAT.