Wednesday, February 13, 2013

Return on Invested Capital

Return on Invested Capital (ROIC) is a sophisticated way of analysing a stock for return on Capital that adjusts for some peculiarities of ROA and ROE. Its worth knowing how to interpret it because its overall a better measure of profitability than ROA and ROE.

Essentially ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing. It removes the debt related distortion that can make highly leveraged companies look very profitable when using ROE. It also uses a different definition of Profits than ROE and ROA, both of which use Net Profits. ROIC uses Operating Profits after taxes, but before interest expenses.

Again, the goal is to remove any effects caused by a company's financing decisions -does it use debt or equity?- so that we can focus as closely as possible on the profitability of the core business.
The true operating performance of a firm is best measured by ROIC, which measures the return on all capital invested in the firm regardless of the source of the capital. The formula for ROIC is deceptively simple

Return on Invested Capital

Invested Capital =Total Assets - Non-Interest bearing Current Liabilities - Free Cash Flow
(Non-interest bearing current liabilities usually are Accounts Payable and other Current Assets)

You may also want to subtract Goodwill, if its a large percentage of Assets.
What does all this mean to you if you hear someone talking about ROIC? Simply that you should interpret ROIC just as you would ROA and ROE - a higher Return on Invested Capital is preferable to a lower one!

Rough benchmarks for analysing a firm's ROIC

In general, any non-financial firm that can generate consistent ROICs above 15 percent is atleast worth investigating. And if you can find a company with consistent ROICs over 30%, there's a good chance you are really onto something.