What Is a Good Return on Invested Capital? (ROIC)

What Is a Good Return on Invested Capital (ROIC)?

Return on Invested Capital (ROIC) is a crucial metric when assessing a company's profitability and efficiency. ROIC helps investors determine how well a business turns its invested funds into profits. A high ROIC indicates that a company is investing its capital in a way that generates solid returns. But what exactly is considered a good ROIC?

Understanding ROIC: How It Works

What Is ROIC?
ROIC is a measure of how efficiently a company allocates its capital to generate profits. It provides a clear view of the returns generated on the funds invested in the business by both equity and debt holders. Calculated as a percentage, ROIC helps investors assess a company's effectiveness in turning its investments into net profits.

How To Calculate ROIC

To calculate ROIC, you need two key figures: Net Operating Profit After Taxes (NOPAT) and invested capital. The formula is:

ROIC = NOPAT / Invested Capital

• Net Operating Profit After Taxes (NOPAT): This metric represents a company’s operating income adjusted for taxes, assuming no debt. It provides a cleaner view of profitability by focusing solely on operational performance.

• Invested Capital: This includes all capital provided to a company by both debt and equity holders. It’s calculated as the sum of long-term debt, short-term debt, and shareholders' equity.

A simple example could be a company with a NOPAT of $500,000 and invested capital of $2,000,000, resulting in an ROIC of 25%. This means that for every dollar invested in the company, it generates $0.25 in profit.

What Is a Good ROIC?

A good ROIC typically exceeds the company’s Weighted Average Cost of Capital (WACC) by at least 2%. This benchmark is important because it indicates that the company is generating more returns than it costs to finance its operations. Here’s a deeper dive into what this means:

• ROIC > WACC: If a company’s ROIC is greater than its WACC, it means the company is creating value for its shareholders. For instance, if a company has an ROIC of 15% and a WACC of 10%, the 5% spread shows that it is earning more on its investments than it costs to fund those investments.

• ROIC = WACC: When a company’s ROIC equals its WACC, it is operating at break-even in terms of capital efficiency. While this isn’t necessarily a negative sign, it suggests that the company is neither creating nor destroying value.

• ROIC < WACC: This scenario indicates a potential problem, as the company is not generating enough returns to cover its cost of capital. A consistent ROIC below WACC may signal poor investment decisions or financial inefficiencies.

Key Factors Influencing ROIC

1. Industry and Sector Variability
ROIC benchmarks can vary significantly across industries. Capital-intensive sectors like manufacturing or utilities often have lower ROICs than technology or service-oriented businesses. Investors should compare a company’s ROIC against its industry peers to gain a better perspective.

2. Economic Conditions
During economic downturns, companies may see a dip in their ROIC as demand slows and profit margins tighten. Conversely, in periods of economic growth, a well-managed company might achieve a higher ROIC through increased sales and more efficient use of capital.

3. Company Lifecycle
Young companies often reinvest their profits to fuel growth, which may temporarily suppress their ROIC. In these cases, investors should consider whether lower initial returns could translate into higher profitability in the long run as the business matures.

Comparing ROIC with Other Metrics

ROIC vs. Return on Equity (ROE):
While ROIC measures returns on both debt and equity capital, ROE focuses solely on returns generated from shareholders’ equity. ROIC provides a more comprehensive view of a company's capital efficiency since it accounts for all invested funds.

ROIC vs. Return on Assets (ROA):
ROA measures how efficiently a company generates profits from its assets, while ROIC evaluates the returns on the capital specifically invested into the business. ROIC can be more informative for assessing businesses that rely on significant capital investment.

Why ROIC Matters for Investors

1. Indicator of Competitive Advantage
A company with a consistently high ROIC often has a strong competitive advantage. This could be due to factors like a unique product, efficient operations, or brand loyalty that allows the company to command better pricing and margins.

2. Predictor of Long-Term Stock Performance
Companies that maintain an ROIC above their WACC tend to generate higher returns for their shareholders over time. This makes ROIC a valuable tool for investors looking to build a long-term portfolio of quality businesses.

3. Helps in Valuation Analysis
ROIC plays a critical role in valuation models like discounted cash flow (DCF) analysis. It helps investors understand whether a company's investments are likely to drive growth and whether its stock price reflects its ability to generate returns above its cost of capital.

Limitations of ROIC

1. Susceptibility to One-Time Charges
One-time expenses, such as restructuring costs or litigation charges, can distort a company’s NOPAT and, by extension, its ROIC. It’s crucial for investors to adjust for these factors to get a clearer picture of the company’s ongoing profitability.

2. Not Suitable for All Industries
For certain sectors like banking, where capital is constantly reallocated, ROIC may not be the best metric. In such cases, metrics like Return on Equity (ROE) might offer better insights into a company’s performance.

3. Impact of Accounting Decisions
Changes in accounting practices can impact reported NOPAT and invested capital, leading to fluctuations in ROIC. Investors should analyze a company’s financial statements carefully to understand any changes that might affect these figures.

Conclusion: What Makes a Good ROIC?

A good Return on Invested Capital generally surpasses the company's WACC by at least 2%, indicating that the business is generating excess returns and effectively using its capital. When evaluating ROIC, investors should also consider industry context, economic conditions, and the company’s lifecycle stage. By focusing on companies with a strong and sustainable ROIC, investors can identify businesses that are well-positioned for long-term growth and profitability.

Happy investing!
Josh

The information is provided for educational purposes only and does not constitute financial advice or recommendation and should not be considered as such. Do your own research.