Understanding Return on Invested Capital (ROIC) Ratio
Return on invested capital (ROIC) measures how well a company can convert its invested capital into profit. ROIC is one of the most reliable profitability and performance ratio used by investors. It is calculated by dividing a company's Net Operating Profit After Tax (NOPAT) by Net Invested Capital.
ROIC should be greater than the Weighted average cost of capital (WACC). Comparing ROIC with WACC will give an idea, whether invested capital is used effectively by a company or not.
The formula to derive ROCE
Net Operating Profit After Tax (NOPAT) -
NOPAT is the amount of profit that the company makes after taxes based on continuous operations. It indicates how well the company is performing in generating profits.
Formula to calculate NOPAT is [EBIT X (1- Tax)]
Net Invested Capital -
It is the sum of money invested by debtholders and shareholders. Companies issue bonds and securities or sell stocks when they need capital to expand. Expansion of a company can include the purchase of assets like land, building, machinery, etc. And here shareholders are who purchased the shares, and debtholders are those people who buy Bonds.
Example of Return on Invested Capital:
For the financial year Tata Steel Company reported Net Operating profit after tax (NOPAT) Rs 53739 Cr. and Net invested capital as Rs 923936 Cr.
The value as per the formula [ROIC = (Net operating profit after tax/Net invested capital) x 100] is calculated as (53739 / 923936) x 100 = 5.82%.
Investors should be looking for a company with a high ROIC. ROIC with 2% or higher is considered good.
ROIC should be greater than the Weighted average cost of capital (WACC). Comparing ROIC with WACC will give a better understanding.
Comparing the ROIC of the company with its peers can give a better understanding of how well the company is utilizing its invested capital.
While looking at ROIC, the following points should also take into consideration:
ROIC of 2% or higher is considered the company is value creator and efficiently managing its invested capital to generate profit, and a low ratio than 2% is considered a value destroyer.
ROIC should be greater than the Weighted average cost of capital.
ROIC greater than at least 2% than WACC is value creator, as it indicates excess returns of the company may be, reinvested for growth and expansion.
Lower ROIC is viewed as a value destroyer as it indicates that the company has limited growth opportunities.
ROIC indicates the returns the company gets from invested capital through both the debtholders fund and shareholders fund. Higher returns show the company is generating more profits.
How to use ROIC effectively
Investors should look for ROIC greater than 2% or higher.
While analyzing ROIC, it will be better to compare ROIC with WACC. It will give a better understanding.
Comparing the ROIC of the company with its peers can give a better understanding of how well the company is utilizing its invested capital than its competitors.
For better analysis, we must look at other financial metrics like Return on Capital Employed (ROCE)
, Return on Equity (ROE)
, Return on Assets (ROA)
|| Strong Bullish
|3 to 6
|2 to 3
|| Mild Bullish
|1 to 2
|0.5 to 1
|| Mild Bearish
|0 to 0.5
||Very Low Return
|| Strong Bearish
||Extremely Low Return