ROIC (Return on Invested Capital): Beyond the Investopedia Treatment

Return on Invested Capital equals a company’s Net Operating Profits After Taxes (NOPAT) in a period divided by its Average Invested Capital in that period, where Invested Capital consists of Debt + Equity + Other Long-Term Funding Sources, such as Preferred Stock; ROIC tells you how efficiently a company is using its total capital to generate profits.

ROIC (Return on Invested Capital) Definition: Return on Invested Capital equals a company’s Net Operating Profits After Taxes (NOPAT) in a period divided by its Average Invested Capital in that period, where Invested Capital consists of Debt + Equity + Other Long-Term Funding Sources, such as Preferred Stock; ROIC tells you how efficiently a company is using its total capital to generate profits.

ROIC Definition

NOPAT is defined as Operating Income * (1 – Tax Rate) and should ideally be adjusted for non-recurring charges; see the articles on non-recurring expenses and EBITDA for more.

You can see a simple ROIC calculation for Best Buy below:

ROIC Calculation for Best Buy

If two companies are similar, but one has a higher ROIC, the company with a higher ROIC should, in theory, trade at higher valuation multiples (e.g., P / E, TEV / EBITDA, etc.).

The fact that Best Buy trades at lower multiples than Target despite a much higher ROIC gives us a hint that something may be “off” with their valuations:

ROIC Calculations for Best Buy vs. Target

You often use ROIC to cross-check your assumptions in a 3-statement, DCF, or LBO model, and see if something like a higher exit multiple is justified.

For example, if a private equity firm buys a company for 10x EBITDA and plans to sell it for 12x EBITDA, can you justify this assumption based on an increasing ROIC over the holding period?

If not, you may need to revisit your assumptions.

While ROIC is a useful metric, it is also defined inconsistently, it’s less meaningful for certain industries and company types, and it’s not always practical to use since it requires projections for both Debt and Equity.

Files & Resources:

ROIC – Slide Presentation (PDF)

NOPAT and ROIC Calculations for Target and Best Buy (XL)

ROIC in a Simple LBO Model (XL)

Best Buy – Key Extracts from 10-K (PDF)

Target – Key Extracts from 10-K (PDF)

Video Table of Contents:

0:52: The Short Answer About ROIC

4:53: Part 1: ROIC Calculations for Target and Best Buy

8:08: Part 2: ROIC in LBO and DCF Models

9:26: Part 3: Issues with ROIC and Its Use in Models

11:08: Recap and Summary

ROIC Calculation and the ROIC Formula in More Detail

The basic formula for ROIC is simple:

ROIC Formula

You should use the book value of each item in the denominator – in other words, each item’s value on the Balance Sheet, not its market value.

You use the market value of Debt and Equity in the Enterprise Value calculation, but not in ROIC because you’re assessing the company’s efficiency based on its total capital raised or generated.

The market value of this capital is irrelevant because it doesn’t represent the company’s initial actions to get this capital.

There are a few other questions with this calculation:

Q1: Which non-recurring charges do you add back to calculate Operating Income or EBIT?

A: We recommend being quite conservative here and adding back only true non-recurring expenses, such as those appearing in only 1 out of 5 historical years.

For more, see our EBITDA tutorial.

Q2: Which Tax Rate do you use?

A: If there have been no major changes, we prefer the historical average over the past 3 – 5 years.

If you get a nonsensical result, such as a (25%) or 75% tax rate, you could use the statutory corporate tax rate in the company’s country.

Q3: What about Leases? Do you subtract Cash in the Invested Capital calculation?

A: We prefer not to subtract Cash in the ROIC calculation because doing so often inflates ROIC for companies with high Cash balances.

It also creates comparability issues between companies with high vs. low Cash numbers.

You could subtract Cash if you want, but if you do so, you must apply the rule consistently to all the comparable companies you’re analyzing.

Leases and lease accounting are complex issues, but for U.S.-based companies that follow U.S. GAAP, we generally do not add Lease Liabilities to Invested Capital.

That’s because if we add them, we must adjust EBIT by adding back the associated Rental Expense – and to make it even more confusing, some companies calculate and define this expense differently.

For example, some firms add back just the “estimated Interest portion” rather than the entire Rental Expense, which is incorrect because the Lease Liability represents the Present Value of the full Rental Expense over its term.

If the company follows IFRS accounting rules, you need to address leases in the calculations because the expenses for Operating and Finance Leases are split into Lease Interest and Lease Depreciation.

You have two main options here:

Option #1: Add the Lease Liabilities to Invested Capital and add back the Lease Depreciation to EBIT so that it’s “EBIT Before the Lease Expense.”

Option #2: Do not add the Lease Liabilities to Invested Capital and deduct the Lease Interest from EBIT so that it’s “EBIT After the Lease Expense.”

If we adjust Target and Best Buy’s numbers by adding the full Lease Liabilities and adding back the full Rental Expense, we get the following results:

ROIC - Lease and Cash Adjustments

The difference isn’t huge, but the gap between these companies narrows as Best Buy’s ROIC falls and Target’s ROIC only falls slightly.

Since Leases are far more important for Best Buy on a relative basis, the lease adjustments may be warranted in this case, even though both companies follow U.S. GAAP and, therefore, use simplified accounting for their Operating Leases.

ROIC in LBO and DCF Models

The ROIC metric lets you “sanity-check” your long-term forecasts in leveraged buyout and discounted cash flow models.

For example, if you assume a higher exit multiple in a 3-statement model or LBO model, does the company’s ROIC increase over the holding period?

If not, you must revisit the assumptions because your forecast may not support this multiple expansion.

For example, in this 3-statement model for Coles, a grocery retailer in Australia, we assume a higher exit multiple (~10x to ~12x), but the ROIC (or “Return on Capital”) also increases from ~15% to ~20% over the period:

ROIC and Exit Multiple Expansion for Coles

If the ROIC stayed the same, this increased exit multiple would be much harder to justify.

In a DCF model, you generally want the ROIC to decline and move closer to the company’s Weighted Average Cost of Capital (WACC) over time.

Even if the company’s ROIC is high initially, such as 30 – 40%, it should not remain at that level indefinitely against a much lower WACC, such as 10 – 12%.

You may still see a difference going into the Terminal Period, but ROIC should be closer to WACC by then.

Issues with ROIC and Its Use in Models

Even though ROIC is useful, it’s not especially common in investment banking or banking-style models presented in pitch books.

A few factors explain this:

Issue #1: Inconsistent Definitions and Calculations – See all the issues above with Cash and Lease Liabilities. Many companies also have their “own versions,” such as Return on Capital Employed (ROCE), Return on Capital (ROC), and others.

These discrepancies make “apples-to-apples” comparisons difficult in some cases.

Issue #2: Not Meaningful for All Companies – ROIC is the most useful for large, mature companies growing at moderate-to-slow rates.

It’s not relevant for tech or biotech startups, and it’s not used in sectors such as financial institutions or real estate (REITs).

Issue #3: Extra Work—If you have a simple “cash flow only” model, you’ll need to complete additional work to forecast the company’s Debt and Equity balances.

You can easily calculate the historical ROIC, but this is not especially useful in models; you need the projected numbers to check your assumptions.

Issue #4: The Client is Always Right – In investment banking, you always do what the client wants because the client is paying your bank huge sums of money for advisory services.

So, even if ROIC indicates that your client’s assumptions are nonsensical, you must follow them – or risk losing the client.

Final Thoughts on the ROIC Metric

Because of all the factors above, ROIC is a more useful metric when you’re in a “critical thinking”-oriented role on the buy-side, such as at a hedge fund, asset management firm, or private equity firm.

In these roles, you can assess company-provided information, pick apart assumptions, and find holes in their logic.

But like any other valuation metric, ROIC is just one tool; it can reveal pricing discrepancies and flawed business plans, but it doesn’t “prove” anything by itself.

You should use ROIC with valuation multiples, the DCF model, and scenario analysis to decide which companies and deals are worth investing in.

About Brian DeChesare

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.