Before investing in a company, investors want to be sure that their hard-earned money will generate returns. But figuring this out can be difficult. That’s why investors look at various metrics to evaluate a company’s financial performance. If you’re curious about how companies make the most out of their money and generate profits, then understanding Return on Invested Capital (ROIC) is vital.
ROIC is a powerful metric that helps you see how efficiently a business uses its invested funds to generate profits. So, let’s dive in and discover how to measure ROIC, the relationship between ROIC and WACC, what it tells you, and its limitations. By the end of this article, you’ll also know what a good Return on Invested Capital is.
What Is Return on Invested Capital (ROIC)?
Return on invested capital (ROIC) is a metric investors use to determine how efficiently a company allocates its capital to generate profits. A high ROIC shows the company is investing its capital in profitable projects.
ROIC is often expressed as a percentage. For instance, a 50% ROIC tells you that for every dollar invested in a company, it would generate 50 cents in income. Some investors go for companies with a consistently high ROIC, as it’s a good sign of business performance.
However, savvy investors compare ROIC to the weighted average cost of capital (WACC) to determine if a company uses its capital effectively.
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ROIC vs WACC
ROIC measures how efficiently a company generates profits from the capital invested in its operations. It is a key indicator of a company’s ability to generate returns for its shareholders.
On the other hand, Weighted Average Cost of Capital (WACC) represents the average cost of financing a company’s operations through debt and equity. It considers the cost of both debt and equity capital and is used to discount future cash flows in valuation models.
For a company to create value for its shareholders and be financially healthy, its ROIC should be higher than its WACC. If ROIC is greater than WACC, the company earns more from its investments than it pays in financing costs to fund those investments. This means it’s generating excess returns for its investors and shareholders, which is positive for the company’s value. Conversely, if ROIC is lower than WACC, the company’s investments are not generating enough returns to cover the cost of capital, indicating a potential loss of value and financial inefficiency.
How To Calculate ROIC
To calculate ROIC, divide Net Operating Profit After Taxes (NOPAT) by invested capital. It’s usually expressed as a percentage.
- NOPAT: measures the company’s earnings assuming it has no debt. So, whether a company is financed with all equity or has debt, NOPAT is calculated to be the same. To calculate NOPAT, subtract cash taxes from Operating Income or Earnings Before Interest and Taxes (EBIT).
- Invested Capital: Refers to the total amount of capital invested in a company, both from debt and equity sources. Invested capital is the sum of long-term debt, short-term debt, and equity.
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What Is a Good Return on Invested Capital Ratio?
One useful benchmark is that a good return on invested capital generally exceeds the company’s WACC by at least 2%. A higher ROIC than WACC is a positive sign, showing the company is using its money wisely and creating value for its investors.
Generally, the higher the ROIC, the better, as it indicates the company is more efficient at making money from its resources. For example, O’Reilly Automotive (ORLY) has an ROIC of 50% versus its peer, Advance Auto Parts (AAP), which has an ROIC of 2%.
It’s important to understand the drivers of the ROIC difference here, but with all else equal, this shows that O’Reilly is the more efficient business.
Limitations of ROIC
ROIC is a valuable financial metric, but it has certain limitations that should be taken into account.
One-time items can distort ROIC. For example, NOPAT in the numerator can be distorted by restructuring charges, write-offs, litigation, and other one-time charges. It’s important that the inputs to ROIC are a reliable measure of the business’s ongoing operations.
ROIC is also less applicable in some sectors than others. For example, using ROIC to evaluate banks isn’t viable because banks use financing for their products (e.g. loans). In this case, Return on Equity (ROE) would be a better metric to evaluate banks.
Finally, young companies may be unprofitable because they are reinvesting profits into the business to grow. If this is the case, ROIC won’t be as helpful for measuring the company’s early profitability.
FAQ Section
How does ROIC affect a company’s stock price?
ROIC can influence a company’s stock price by reflecting how effectively the business generates returns on its capital. Higher ROIC often signals strong operational efficiency, which may lead to higher stock valuations.
What is the difference between ROIC and Return on Equity (ROE)?
The key difference between ROIC and ROE is that ROIC considers both equity and debt, while ROE focuses solely on returns generated from shareholders’ equity. ROIC can potentially give a more comprehensive measure of a company’s overall capital efficiency.
Why should investors use ROIC when analyzing stocks?
Investors should use ROIC when analyzing stocks because it helps measure how well a company utilizes its capital to generate profits, providing a clearer view of its long-term value creation.
Can ROIC help predict long-term stock performance?
Yes, ROIC can help predict long-term stock performance by indicating whether a company consistently generates returns above its cost of capital, a key factor in sustained growth and profitability.
What are some flaws with using ROIC?
One flaw with using ROIC is that NOPAT can be skewed by accounting practices or temporary gains or losses in profits. This can make the ratio less reliable if not viewed alongside other financial metrics and business fundamentals.
TIKR Takeaway
ROIC tells you how well a company uses its money to generate profits. A high ROIC shows that a company is making good use of its resources by investing in profitable projects and investments.
If a company’s ROIC exceeds its cost of capital, this can drive big gains in a company’s stock price over time because the business is creating value for shareholders.
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Disclaimer:
Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks. We create our content based on TIKR Terminal’s investment data and analysts’ estimates. We aim to provide informative and engaging analysis to help empower individuals to make their own investment decisions. Neither TIKR nor our authors hold positions in any of the stocks mentioned in this article. Thank you for reading, and happy investing!
