Return on Invested Capital (ROIC) is a profitability ratio that measures how much profit a company makes with money that shareholders have invested incorporating company’s tax and debt liabilities. As a result, we see a ratio of percentage points, which is then compared to a weighted average cost of capital (WACC).
There are few approaches to the calculation out there, from a basic model to more complicated formulas. However, the one that gives the most accurate result reflecting the company’s true valuation must contain net operating profit after tax (NOPAT).
NOPAT can be easily calculated incorporating tax rate into operating income.
NOPAT = Operating Income * (1-Tax)
Final formula for Return on Invested Capital:
ROIC = NOPAT / (Debt + Equity)
The final ratio gauges how the company performs with its operating capital, thus, as with Return on Equity (ROE), we are seeking a positive ratio. In addition, we want to compare the ROIC ratio to the WACC ratio. As positive outcome we expect ROIC to be higher than WACC. If it was the other way, the company is not making enough money to cover its cost of capital. Simple!
This profitability indicator must be used among the stocks within the same industry. The nature of company business model varies across the sectors and thus, a financial institution is going to have different ratio levels than a software maker.
As an example let’s take two companies from Technology sector – Semiconductor Memory Chips Industry. Micron has ROIC of 20.5% and WACC of 9.5%. This means that company is operating well above the cost of capital and investors are returned net 11%.
On the other hand, Rambus has ROIC of -3.1% and WACC of 9.5%. Not only that ROIC is less than WACC, but it is also negative. Based on this comparison a successful trend trader chooses Micron over Rambus.
Note, the ROIC ratio must not be used as the only indicator when picking the stock. It must always be accompanied by other fundamental indicators since there are also other aspects of the firm’s engine that drives profitability and valuation.