Return on Invested Capital – A better return ratio
Earlier, we looked at how to evaluate companies better with capital-based return ratios like Return on Capital Employed (ROCE) apart from using sales-based return ratios Gross Profit margin, Operating Profit margin, or Net profit margin
One such return ratio which is often considered better is – Return on Invested Capital
What is Return on Invested Capital?
As part of business, capital is provided by Equity Shareholders or Lenders/Debt Providers. Such capital is deployed into the business to generate positive returns.
Moreover, not all capital is actually deployed into the business during the year. Some capital is retained in the form of Cash & Cash equivalent that earn negligible returns.
We need to look at ROIC to understand if the company is successful in generating positive returns on its capital.
ROIC explains how much return is the company making on its capital that is actually deployed into the business.
Higher the ratio, better is the company’s ability to generate higher returns.
Formula for Return on Capital Employed
The formula of the Return on Invested Capital is intuitive.
We take NOPAT in the numerator.
Average Invested Capital in the denominator
We are concerned with Operating Profit but after considering the tax impact on such profits.
Hence, we consider Net Operating Profit After Tax (NOPAT) as a return measure in the numerator.
This amount is nothing but EBIT adjusted for the Income Tax effect.
NOPAT = EBIT * (1 – Tax Rate)
where Tax Rate = (Tax Expenses / Pretax Profit) * 100
All the values can be obtained from the Income Statement.
We will understand the formula better with an example in few moments.
Invested Capital is nothing but the amount of capital that is actually deployed into the business.
Firstly, we consider Equity Capital + Debt Capital as Capital for our analysis. Although, slightly different definitions of Capital may exist.
Since not all Capital is actually employed in the business all the time, we need to consider only the capital that is actually deployed.
Cash & cash equivalent remaining with the company is not always deployed into the business.
Hence, we reduce Cash & cash equivalent from Overall capital to arrive at Invested Capital.
Let us calculate the ratio using an example given below.
How to calculate Return on Invested Capital – Example
For understanding the ratio better, consider two companies Alpha Inc. and Beta Inc.
Assume both the companies are in same sector.
We have been provided with Income Statement for both the companies. The values are in $ million
Further, consider the Balance Sheet extract for the companies.
To calculate return on Invested Capital we need below 2 figures,
- Invested Capital
NOPAT is not directly reported in the Income Statement. We have to calculate it separately.
If you recall, NOPAT is nothing but EBIT (but after factoring for the tax effect).
Before calculating NOPAT, we need the tax rate.
Tax rate = Income Tax Expenses / Pretax Profit
Alpha Inc. = $54 / $180 = 30%
Beta Inc. = $54 / $180 = 30%
NOPAT = EBIT * (1-Tax rate)
Alpha Inc. = $195 * (1- 30%) = $137
Beta Inc. = $200 * (1- 30%) = $140
Invested Capital is nothing but Total Capital less Cash and cash equivalents.
Invested Capital = Equity Capital + Debt Capital – Cash and cash equivalents.
Alpha Inc. = $180 + ($120 + $300) – $300 = $300
Beta Inc. = $190 + ($10 + $100) – $100 = $200
Now that we have all the values, lets us calculate the ROIC for both the companies.
Return on Invested Capital = (NOPAT / Invested Capital) * 100
Alpha Inc. = ($137 / $300) * 100 = 46%
Beta Inc. = ($140 / $200) * 100 = 70%
The above charts summarizes out calculation of ROIC for both the companies.
What does 46% and 70% ROIC mean?
It means on every $100 of Invested Capital of Alpha Inc., it earns $46 as NOPAT
Similarly, on every $100 of Invested Capital of Beta Inc., it earns $70 as NOPAT
Clearly, Beta Inc. earns a higher ROIC. Hence, we may conclude that Beta inc is better at managing its capital better and fetch good returns to its capital providers.
Walmart Inc case study – Calculating ROIC using excel.
Let us understand how to practically calculate the ROIC for US-based retail company Walmart for the year ending 31 Jan 2020.
You can download the template using the below option.
Once you download the template you will see the consolidated Income Statement of Walmart for the past 6 years.
Similarly, the file also has the consolidated Balance Sheet.
To calculate ROIC we need NOPAT and Invested Capital. Let us calculate numerator and denominator.
Net Operating Profit After Tax (NOPAT)
As required, before calculating NOPAT, we need Tax rate and EBIT
Tax Rate = (Income Tax Expenses / Pretax Profit) * 100
= ($4,915/$20,116) * 100 = 24%
Hence, the tax rate is 24%
To calculate EBIT, we reduce all expenses from the Revenue except Interest expense and Income Taxes.
EBIT = Revenue – Cost of sales – SG & admin expenses – Depreciation and amortization
EBIT = $523,964 – $394,605 -97,804 – $10,987 = $20,568
NOPAT = EBIT * (1 -Tax Rate)
= $20,568 * (1 -24%)
Invested Capital = Equity Capital + Debt Capital – Cash and cash equivalents.
= $81,552 + ($575+ $43,714) -$9,465
Now that we have both the values, let us calculate the ratio using Excel.
Return on Invested Capital = (NOPAT / Invested Capital) * 100
= ($15,543/ $116,376) * 100 = 13.4%
What does ROIC of 13.4% indicate?
It indicates that for every $100 of Capital that is actually invested into the business, company generates $13.4 of After Tax Operating profit.
Since this $13.4 of Operating Profit is adjusted for taxes, it gives a better sense as to how well did the company perform at an Operational level.
Higher the ROIC, the better it is as it shows the company’s ability to utilize its capital in an efficient manner.
Before concluding if this ROIC is better or not, we must look at how this ratio has changed over time. Also, we need to compare this with other similar companies in the same industry.
How to Interpret Return on Invested Capital?
As already discussed the ROIC explains the company’s ability to earn Operating Profits on its Invested Capital.
If ROIC is high, it means that the company is most efficient in managing its Invested Capital. It is successful in generating good returns to its capital providers
If ROIC is increasing, it means that the company has a good competitive advantage or moat around its business. Such advantage allows company to keep generating higher and higher returns on its capital.
If NOPAT is high, it indicates the company has good cost control measures in place such that it generates high Operating Profits. Also, Operating profits depends upon the industry dynamics.
Low ROIC would mean that the company is inefficient in utilizing its capital in a better way. It is making investment in projects that are not profitable.
A Falling ROIC would indicate a weakness in the company’s competitiveness or pricing power. Management should take timely actions to avoid investing in projects that erode their Capital.
ROIC will not tell which segment of the business is resulting in higher returns or lower returns as it does not bifurcate the Operating Profits.
ROIC and Weighted Average Cost of Capital (WACC)
Investors often use ratios like ROCE or ROIC to compare with its Weighted Cost of Capital (WACC) to determine if any value is created for them
If company’s ROIC > WACC, value is created
On the contrary, if the ROIC<WACC, value is destroyed.
Hence, management should carefully choose projects/investment whose ROIC is greater than its WACC. Only then it will be able to generate value to its capital providers.
Return on Invested Capital Case Study 1: PayPal Holdings
As part of this case study, let us understand the ROIC profile for Global payment platform provider – PayPal
As evident from the chart above, the company’s ROIC has been increasing since 2015.
If we recall the formula,
Return on Invested Capital = NOPAT / Invested Capital
ROIC of a company will increase if either of the below happens.
- NOPAT increases at a much faster rate than Invested Capital
- Invested Capital decreases at a much faster rate than NOPAT.
In the case of PayPal, it appears both the factors contributed for increase in its ROIC.
From 2015-2019, company’s Invested Capital hardly saw any increase. Rather, if you observe the chart, it was down to $9000 million during 2018.
With constant Invested Capital, company was able to scale up and earn higher operating profits during such period. Hence, NOPAT increased from $1,206 in 2015 to $2,230 in 2019, an increase of almost 85% in just 5 years.
Such an increase in NOPAT with a stable capital base led to higher and higher ROIC for the company. Clearly, the company was successful in generating good returns to its capital providers.
In the next few sections, let us look at how various companies in different industries generate ROIC.
As evident from the chart above, Home Depot has clear increasing trend in its ROIC.
The company, over the past few years, has done a series of buy-back of its Equity Capital. This has resulted in a lower Equity Base or lower Invested Capital
Although, the capital base was reduced, company was able to generate higher and higher Operating profits as part of its business.
Hence, with increasing NOPAT and decreased Invested capital base, the ROIC profile for the company kept on increasing every year.
For the year ending 2019, the company was able to generate $47 as operating profits on every $100 capital invested. Clearly 47% ROIC is considered really great given WACC of such companies will be really low.
As part of example above, we saw the ROIC profile of Walmart.
The company earns Return on Invested Capital in the range of 9% to 12%. Relative to company like Home Depot, this ratio is very low.
Also, if you look at the chart above, the return has been falling for past few years.
In 2015, the ratio was 12% which fell to almost 6% in 2018. Recently, the company was able to increase the ratio back to 12%.
US-based online retail company Amazon Inc. has a volatile ROIC profile.
For the year ending 2015, the ratio was moderate 8%. This jumped to 19% in subsequent year. But again, it fell back to 7% in 2017.
Over the past couple of years, the company is able to have a stable ratio in the range of 19% to 20%.
For the year ending 2019, Amazon’s return on Invested Capital was 19%
Unlike retail companies, tech companies are not highly capital intensive.
They Generate high ROIC in the range of 20% to 30% every year.
Among all the tech-companies under discussion, Facebook was able to improve its ROIC profile significantly.
Back in 2015, the ratio was mere 10%.
Subsequently, with same Capital base, the company was able to generate higher NOPAT. This resulted in ROIC more than double to 24% in 2016.
Since then the company was able to further improve the ratio to almost 30%.
For the year in 2019, Facebook had a ROIC of 24%.
Similar to Facebook, even Microsoft was able to significantly improve its ROIC profile in the past few years.
With sufficient capital already invested into the business, the company was in the position to reap the benefits in the form of higher Operating Profits.
During 2015, company had a moderate ROIC of 11%. This jumped to almost 18% in just 1 year.
From 2016 to 2019, the company’s return on invested capital expanded by almost 33%.
Currently, for the year ending June 2019, the ROCI of Microsoft was 24%
Among other tech companies in the discussion, clearly Google had higher ROIC from beginning.
In 2015, the company comfortably provided $26 as NOPAT on its Invested Capital.
From 2016 to 2019, the company has been earning ROIC in the range of 30% to 37%.
For the year ending 2019, on every $100 Capital invested, the Google was able to fetch $32 as After Tax Operating Profits.
As evident from the chart above Tesla made a phenomenal turnaround in its business.
Back in 2015, the company was losing $30 on every $100 invested as capital into the business. With cash burn happening every year, there was no clear idea as to how long this may continue.
In 2016, the company was able to control most of its costs and due to some competitive advantage, it was able to improve its margins. As a result of this the profile improved significantly.
Since then there is a clear trend of upward ROIC. The company was able to reduce losses and currently earns ROIC which is in negative single digit.
From -30% ROIC to -1% ROIC in just 5 years, the company has kept hope for its capital providers.
Going forward, with increasing competitive advantage and pricing power the company is expected to further expand its operating profit margin which should invariably help in increasing ROIC.
Johnson & Johnson
Johnson & Johnson is a US-based pharma and medical equipment manufacturer having a global presence.
Company has been earning stable ROIC in the range of 19% to 20%.
As part of the case study above we saw how PayPal was successful in increasing its ROIC over the past few years.
Capital base being steady, the company earns higher and higher operating profits every year. Tu
From 10 % in 2015 to 18% in 2019 the company improved its return profile by more than 80%
With increasing shift towards online payments, company appears to have a great growth potential going forward.
As evident from the chart above, US-based Oil Company ExxonMobil clearly has disappointed its investors.
During 2016-2018, the company had a negligible return on its invested capital of around 0%-1%.
Fortunately, in 2019 the company was able to earn 9% return for its capital providers.
Being in Oil business, company has greater exposure to oil price risk. Such a volatility in return profile is very much expected unless the company manages its capital in a really efficient way.
Swadesh conclude the topic of return on invested capital
As iterated many times in this resource, ROIC explains the return on the capital that is actually invested in the business.
Capital intensity differs from industry to industry. We saw how Tech companies are less capital intensive and offer significantly higher return to its capital providers.
Also, low ROIC need not be a company specific matter, instead it may be industry-wide phenomenon. Hence understanding about the industry dynamics before analyzing any company would offer greater insight.
Below are other important recommended resources related to the topic.