Return on Invested Capital (ROIC) Simplified: All You Need To Know

Have you ever considered why two companies with similar revenues produce vastly different outcomes for their shareholders? Why one seems to thrive with each passing year while the other struggles?

The answer often lies in their ability to deploy capital wisely and extract value from it – precisely what return on invested capital (ROIC) seeks to measure.

So, what is ROIC, how is it calculated, and why do investors look at it?

What Is Return On Invested Capital (ROIC)?

Return on Invested Capital (ROIC for short) is a widely used and referred to investing metric. It tells investors how effectively a company deploys its capital to profit-generating investments. The higher a company’s ROIC, the less capital it must invest to generate profits. 

For example.

If a company has a return on invested capital of 30%, to generate £120,000 in profit, it must invest £400,000. A company with an ROIC of 20% would have to invest £597,000 – almost £200,000 more for the same profit.

Effective capital allocation can be one of a company’s many competitive advantages. It’s advantageous if a company can invest less capital and earn the same or higher profits.

ROIC Formula

ROIC is one of those metrics with a simple formula but several interpretations. For this reason, investors and analysts will often have different values for it.

The simple formula that computes a company’s return on invested capital is as follows.

Where:

• NOPAT = Net Operating Profit After Tax
• Invested Capital = The capital invested in the business

As the name suggests, NOPAT is the company’s operating profits adjusted for tax. To find a company’s net operating profits after tax:

Or

Some companies will report their effective tax rates in their annual reports; others won’t. To calculate it, divide the company’s tax expense by its profit before tax.

Invested Capital Interpretations & Calculation Methods

Here’s where the simple formula becomes not so simple – the interpretations and calculations of invested capital.

There are three primary ways to calculate invested capital. 

Method 1

The first method uses total assets, non-operating assets, and non-interest-bearing current liabilities (current liabilities that aren’t subject to interest).

Invested Capital = Total Assets – Non-Operating Assets – Non-Interest-Bearing Current Liabilities

Method 2

The second method deducts non-operating assets from the sum of a company’s book value of debt and equity.

Invested Capital = Total Debt + Shareholders’ Equity – Non-Operating Assets

• Total Debt = the company’s total debt as stated on the balance sheet
• Shareholders’ Equity = the company’s total equity as stated on the balance sheet
• Non-Operating Assets = assets that a company doesn’t use in its core operations, like excess cash and cash equivalents and marketable securities

Method 3

The final method uses non-cash working capital and non-current assets.

Invested Capital = Non-Current Assets + Non-Cash Working Capital

Section Summary

In theory, the three methods should yield the same results. This is because invested capital is calculated from the balance sheet, and the balance sheet is always in balance (assets = liabilities + equity or assets – liabilities = equity).

However, in practice, differences may arise due to variations in how components are defined, calculated and adjusted.

ROIC Calculation Examples

To show how ROIC is calculated, we’ll use financials from Alphabet’s 2023 annual report. Alphabet is the parent company of Google.

Table 1: Extracts from Alphabet’s 2023 Annual Report

Table 2: Calculations of Additional Required Items

Since NOPAT will be used in all calculations, let’s get that calculation out of the way.

NOPAT = $84,293 x (1 – 13.9%)

NOPAT = $72,576 million

Now, to ROIC using the three different methods of calculating invested capital.

Method 1

Table 3 calculates Alphabet’s ROIC when the following formula for invested capital is used:

Invested Capital = Total Assets – Non-Operating Assets – Non-Interest-Bearing Current Liabilities

Table 3: ROIC Calculation (in millions of $, except ROIC)

Method 2

Table 4 calculates Alphabet’s ROIC when the following formula for invested capital is used:

Invested Capital = Total Debt + Total Shareholders’ Equity – Non-Operating Assets

Table 4: ROIC Calculation (in millions of $, except ROIC)

Method 3

Table 5 calculates Alphabet’s ROIC when the following formula for invested capital is used:

Invested Capital = Non-Current Assets + Non-Cash Working Capital

Table 5: ROIC Calculation (in millions of $, except ROIC)

Section Summary

Despite the various ways of calculating invested capital, we get to the same ROIC of 34.6%.  

This is not always the case, though. As mentioned above, differences may arise due to how components are calculated and adjusted.

Why Investors Look At ROIC (with Real-World Examples)

Although ROIC is a return metric, it gives investors more information than just the company’s ‘returns’ and capital allocating ability. 

ROIC Can Signify A Competitive Advantage

Return on invested capital can suggest a competitive advantage: a company’s ability to protect its long-term profits. A high ROIC can imply that a company is doing something others aren’t. 

Think of Meta Platforms (the parent company of Facebook, WhatsApp, Threads and Instagram) with a 2023 ROIC of 23%.

Compared to its social media competitors, like Pinterest (-1% ROIC) and Snapchat (-19% ROIC), Meta has a superior capital allocating ability, potentially signifying that the company benefits from something they aren’t – a competitive advantage. 

And this is true.

One of Meta’s competitive advantages is network effects (the company gets better as more people use its family of social media apps). According to the company’s 2023 third-quarter report, Meta had 2.09 billion daily active users on Facebook alone. That figure grows to 3.14 billion after accounting for WhatsApp and Instagram. 

With those figures and a 2023 ROIC of 23%, Meta can invest significantly less capital into its business and generate higher returns than its competitors.

It’s worth noting that while Pinterest and Snapchat have been around for some time, they are still young in the investing world – they only began trading publicly in 2019 and 2017, respectively. This skews the comparison somewhat.

ROIC Can Be Used To Assess A Company’s Management Team

Part of researching a company is assessing the management team, which can be challenging. Since ROIC shows how effectively a company’s management team allocates capital, it can be used for management assessment.

A case can be made for Apple being one of the best-run companies in the world – the company has a 10-year median ROIC of 29% and has rewarded shareholders with over 1,296% return since 2011 (when Tim Cook became CEO) at the time of writing. 

Apple’s 2022, 2023 and 2024 returns on invested capital were 52.6%, 53.0% and 53.9%, respectively. In other words, for every USD$100 Apple invested during those years, the company generated over USD$50 – half of the company’s invested capital became profits.

These figures suggest that Apple’s current management team are efficient and effective capital allocators (they know how to put the company’s capital to good use). 

ROIC should be used alongside the company’s return on equity (ROE) and return on capital employed (ROCE) when assessing a management team’s capital-allocating qualities. Management’s length of tenure, compensation package and capital-distributing skills (dividend payments and share buybacks) should also be considered. 

An Explanation For A Company’s Above-Average Value

Another reason investors look at ROIC is to understand why a company may trade at a premium compared to its peers and the market. 

Some companies are so good at allocating capital and producing shareholder value that they justify their high valuations, and Mastercard fits this description perfectly.

The company has a 10-year median ROIC of 44.3% (for every USD$100 they invest in the company, USD$44.30 of profit is generated). To put this into context, Mastercard’s main competitor’s (Visa) 10-year median ROIC is 21.4% – literally half. 

Mastercard’s lofty ROIC can be one of many reasons the company trades above the market average price-to-earnings (PE) ratio.

A Good Return On Invested Capital? 

An acceptable return on invested capital is subjective and varies from investor to investor. Some investors think a 15% ROIC is suitable. Others think it’s too low.

What’s most important, or at least should be, is that the company’s ROIC exceeds its weighted average cost of capital (WACC). WACC is a collective term for the average:

• Interest rate on the company’s debts and other interest-bearing liabilities
• The minimum required return investors expect for investing in the company

When ROIC > WACC, the company makes more money than it costs to finance; capital is allocated effectively, and shareholder value is created.

When ROIC < WACC, the company makes less money than it costs to finance; capital is poorly allocated, and shareholder value is destroyed.

Summary 

At its core, Return on Invested Capital (ROIC) reflects a company’s ability to make smart investment-related decisions and effectively allocate its capital. Whether it’s used to highlight a competitive advantage, assess management’s skill in capital allocation, or explain a company’s premium valuation, ROIC provides invaluable insights for investors.

Understanding ROIC equips investors with the tools to separate the great from the good, the efficient from the wasteful, and the visionary from the ordinary. So, as you continue your investing journey, remember: ROIC isn’t just a formula – it’s a lens to view a company’s true potential and its promise to deliver lasting value.

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