Apr 10

Return on invested capital (ROIC)

by David Harper, CFA, FRM, CIPM

FinStatements | |

 

We posted an 18-minute movie where I walk through the calculation of ROIC using Dell's financials (from fiscal year ended 2/3/2006).

Three virtues of ROIC

Why is ROIC popular? At least three reasons:

  • Like ROA and unlike ROE, ROIC is not distorted by a company's capital structure (the mix of debt and equity). Like ROA, it represents the return to both classes of investors, debt and equity. At least on a pretax basis (more below), it will not change simply because the company's leverage shifts.
  • It is a key component in economic value added (EVA), where annual EVA (aka, economic profit) = Invested Capital x [ROIC - WACC]. The difference between ROIC and the cost of capital (WACC) is the economic spread. A company that earns more than its cost of capital is said to be creating shareholder value.
  • Along with other metrics, it can be helpful in analyzing a company that has made several acquisitions. For example, I recently analyzed Oracle (ORCL). Because Oracle has acquired 20+ companies in recent years, an organic growth analysis is challenging. ROIC is a way of analyzing the return on capital used to buy companies.

Invested capital = Assets - NIBCLs

The denominator of ROIC is invested capital. Invested capital = Assets - NIBCLs. We start with Total Assets because this is the left-hand side of the balance sheet and, by definition, it equals everything on the "right-hand side" of the balance sheet:

But the right hand balance sheet contains more than invested capital. So we subtract the stuff that isn't invested capital. In particular, current liabilities include both interest-bearing liabilities (e.g., current portion of long-term debt) and non interest-bearing current liabilities (NIBCLs).

A good example of NIBLCs is accounts payable: vendors who want their bills paid aren't really investing in the company. So, by this logic, we subtract short-term obligations that do not represent true capital (i.e., sources of financing). If we subtract NIBCLs, we ought to be left with equity, long-term debt, and short-term debt (by chance, Dell had zero interest-bearing current liabilities, IBCLs).

To summarize, Total Assets minus non interest-bearing current liabilities (NIBCLs) equals Invested Capital (i.e., everything on the right-hand side of the balance sheet except for stuff that isn't really a source of investor funds):

 

ROIC = EBIT/Invested Capital

Return on invested capital (ROIC) is equal to earnings before interest & taxes (EBIT) divided by Invested Capital. In Dell's case, the invested capital is low, so the ROIC is very high:

 

For comparison's sake, we also calculated ROA in the movie. ROA is simply EBIT divided by Assets. In this case, $4,574/$23,109 = 19.8%.

Gross (before D&A) versus Net (after & D&A)

The above ratios are really both returns on net capital: net capital in the case of ROIC, and net assets in the case of ROA. We could get nearer to a cash measure by adding back depreciation and amortization (D&A, which are noncash charges). Here is the thing to remember about return ratios: you want the numerator to be consistent with the denominator. If we add back depreciation (i.e., the income statement line) to the numerator, we want to add back accumulated depreciation to the denominator (i.e., the corresponding balance sheet account). The numerator income-flow number should "match up" to the corresponding denominator capital-stock number.

If we "gross up" ROA, we get return on gross assets (ROGA). However, in addition to adding depreciation and amortization to the numerator, we need to add accumulated depreciation and amortization to the denominator. In this way, ROGA is EBITDA divided by Gross Assets. In Dell's case, that equals about 20.1%.

ROA is sometimes called RONA (return on net assets; i.e., after depreciation) in order to distinguish it from ROGA (return on gross assets; i.e., before depreciation and amortization). We can do a similar thing to convert ROIC (return on net invested capital) into ROGC (return on gross invested capital).

 

Buyer beware

In the movie, I mention a few reminders/caveats about the limitations of ROIC:

  • I used net/gross assets at the end of the fiscal year. It is technically superior to use average assets during the period (if you think about it, this follows from our consistency principle: the numerator is EBIT during the year, so it more naturally matches to average assets over the same period)
  • Also, a reminder: these are all pretax ratios. As in, the EBIT or EBITDA is before taxes. You can also calculate after-tax ROA and ROIC
  • Very important: we took the balances directly from the balance sheet. That is called 'book values.' The book equity value is the residual equity on the balance sheet. But this is very different from the market value of the equity (in Dell's case, the market value will be several multiples of the book value). We could alternatives calculate these metrics based on market values instead of book values.

Comments

  1. K 01 May 2007

    Fantastic Article!! told me exacctly what i was looking for!

  2. Carlos Roman 23 Sep 2007

    You mentioned in the video that we can download the excel with the Dell example. can you tell me where to download the excel from?

    Thanks,
    Carlos

  3. Doug 10 Oct 2007

    I’m confused.  Shouldn’t EBIT be $4,374 instead of $4,574?

    Thanks

    Doug

  4. Jake Nelwood 11 Dec 2007

    FINALLY!  ROIC being non-GAAP, there is a general but not specific agreement on how it should be calculated.  The definition here is the simplist and clearest I’ve found.

  5. yaseranwar 24 Dec 2007

    Awesome article!

Leave a Comment