Quick Accounting Basics: ROIC

Return on invested capital (ROIC) is probably the most important metric in value investing. After a quick analysis, it seems very obvious why ROIC is such a critical metric in assessing a company's prospects.

If I were judging an investment, and I could only ask three questions, I'd probably ask: What kind of returns can I conservatively expect? How much do I have to invest to get those returns? And for how long can I get those returns? In other words, I want to know my return on invested capital, and I want to know how long that ROIC will last.

Thus, earnings growth is a poor metric by which to judge a company. After all, if a company with $10 million in net income takes on $1 billion in debt and, after interest costs, earns an additional $10 million, that will increase earnings by 100%, but the ROIC on the additional investment will only be 1%. Clearly, this is not a great company, but an investor focused on earnings growth and not ROIC would miss this fact. Think of this like a basketball player who doubles his points-per-game average from 10 to 20. This sounds great, but if it takes him 30 shots to do it, then his field-goal percentage will plummet, and he's actually hurting his team.

How to calculate ROIC
Although the ROIC calculation is a little complicated, with some practice it actually starts to seem very simple. The formula is designed to compare all companies on an apples-to-apples basis. The first part of ROIC is the return. This is commonly calculated as after-tax operating income. Operating income, or operating revenue minus operating expense, is the purest form of judging a business's results. Operating income strips out non-recurring items and interest costs, which (excluding those of financial-service firms) don't have much to do with the actual business itself. The formula for the return is:

(1 - tax rate) * (earnings before interest and taxes)

Invested capital (IC), as you would imagine, measures how much capital a company has invested in its business. Although there are many different ways of measuring IC, in general, I calculate this as:

(total assets - cash) - (non-interest bearing current liabilities)

Basically, this equation says that the capital invested is the sum of all the assets, and subtracts out the assets that haven't yet been invested (cash and cash equivalents). Non-interest-bearing current liabilities are also subtracted out because they represent "interest-free" loans. For example, if I own a clothing store and a supplier extends me credit to buy and sell his apparel, I didn't have to expend any capital to get the use of the assets (the clothes), so this doesn't go into the IC equation. What we're left with is the total invested capital.

So simply dividing these two parts leaves you with:

ROIC = ((1 - t)(EBIT)) / ((A - cash) - (non-interest-bearing current liabilities))

Again, this is the after-tax return the business earns on its capital. If I apply this formula to Costco (Nasdaq: COST  ) , Target (NYSE: TGT  ) , and Wal-Mart (NYSE: WMT  ) , all of which have been stellar stocks over the years, I calculate the ROIC of each for the last fiscal year as 14.5%, 11.5%, and 13.5% respectively. (Target's ROIC would probably be more in line with the others if not for its credit card business.) These ROICs, which are better than the average cost of capital, indicate that these firms are creating shareholder value.

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. Costco is a Stock Advisor recommendation and Wal-Mart is an Inside Value selection. The Motley Fool has a disclosure policy.


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  • Report this Comment On September 05, 2010, at 10:16 AM, xmonika wrote:

    Interesting. Please could you futher explain how to calculate ROIC for COST in last fiscal year (2009 I suppose). I got 12,5% depending on which values to deduct in denominator. Which values exactly did you use?

  • Report this Comment On September 08, 2010, at 5:26 PM, ooalex66 wrote:

    I can't get that percentage either. Here are my calculations for Costco based on the financial info provided on fool.com for Aug 2009.

    (1-.35)(1,822) /(21,979 - 3,157 - 1,190) = .067 or 6.7%

  • Report this Comment On September 08, 2010, at 7:01 PM, ooalex66 wrote:

    A correction to my previous comment since this article was written in 2007. Here are the numbers for August 2007. Still not what is calculated above.

    (1-.35)(1,772.62) /(19,606.59 - 2,779.73 - 1,156.26) = .0735 or 7.35%

  • Report this Comment On August 15, 2011, at 4:28 AM, stringchopper wrote:

    would love to see some updated examples or some clarification of the numbers, per previous comments from the Foolish Readers above.

  • Report this Comment On September 07, 2011, at 5:13 PM, LeeOsb wrote:

    Quick question, should the numerator always represent 12 months of data? If I look at a report today many companies are only reporting 6 mos of NOPAT, can I use that or should I look at it for 12 mos of NOPAT?

  • Report this Comment On November 25, 2011, at 8:09 PM, f80d wrote:

    Hello All,

    I could not reproduce the ROIC either. Could someone pick a specific company, with recent data, and work the problem?

    Thanks,

    f80d

  • Report this Comment On May 31, 2013, at 8:27 AM, JohnCLeven wrote:

    Morningstar does all the ROIC work for you. (Though it's always wise to independently verify the numbers.)

    Morningstar defines Invested Capital as (Total Assets) - (Cash) - (Non Interest-Bearing Current Liabilities)

    Here's the key ratios page for COH, my largest personal holding (21% of my portfolio). COH ranks in the top 1% of companies by 10 year average ROIC.

    http://financials.morningstar.com/ratios/r.html?t=COH&re...

    Less than half of public companies have 5 yr avg ROIC above 8%. Keep in mind that most businesses have costs of capital between 6% and 9%, so MANY of those companies generating 8% ROIC aren’t really adding value.

    Generally, I don’t find ROIC below 12% acceptable. Only about 20% of companies can sustain ROIC above 12% over the long term. That's a good benchmark to separate the really good companies from the rest.

    The real all stars, however, are those that sustain ROIC over 20%. Only about 8% of companies have 5 yr avg ROIC’s over 20%. You’ll find a bunch of those among my active CAPs outperform picks.

    Also, you screen for 5 yr avg ROIC via the google stock screener.

    https://www.google.com/finance?ei=a5WoUdCCLqLA0AGBDQ#stocksc...

    Hope that helped!

    p.s. Check out COH, IBM, CHRW, LO, PM, BBBY, ROST, and VAR.

  • Report this Comment On May 31, 2013, at 8:27 AM, JohnCLeven wrote:

    Just realized this article is 2 years old lol.

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