Return on Invested Capital

Quick Summary
1. Calculate ROIC based on reported accounting figures.
2. Incorporate adjustments for operating leases and R&D expenses.
3. Make adjustments for goodwill.
4. Smooth out extraordinary items over time.
5. Make adjustments for minority interests.
6. Look at industry averages and decompose ROIC to aid in projecting future returns on capital.

1. ROIC Calculation
Return on invested capital (ROIC), otherwise known as return on capital (ROC), is one of the primary drivers of a company’s value. In addition to growing profits over time, management maximizes shareholder wealth by increasing a company’s long-run ROIC. For this reason, analysts often compare a company’s ROIC to its cost of capital (i.e. the WACC) to measure if the company is creating or destroying wealth. In a valuation context, it is critical to forecast this ratio well.

ROIC is calculated as after-tax operating income divided by the book value of invested capital. In its most basic form, earnings before interest and tax (EBIT) is used to estimate operating income and invested capital is the sum of book values for equity and debt. The tax rate used is the effective tax rate (=tax expense / taxable income).

ROIC = [EBIT x (1 ─ T)] / (Debt + Equity)

ROIC should represent profits generated from the company’s core operations, after income taxes. The drawback to the above equation is that EBIT may include non-operating revenues and expenses. A modified version of the numerator is net operating profits less adjusted taxes (NOPLAT), which allows for a greater degree of specificity on what is included in the calculation.

NOPLAT = (Revenue – COGS – SG&A – Depreciation – Amortization) – Adjusted taxes

Adjusted taxes = (Reported taxes – Taxes on non-operating income) + Tax shield on interest expense – Increase in deferred taxes

Taxes on non-operating income = Non-operating line items * Marginal tax rate

Tax shield on interest expense = Interest expense * Marginal tax rate

When using the capital-based approach to calculating invested capital (i.e. debt + equity), the figure is at risk of reflecting non-operating asset and liabilities. As a general rule of thumb, if certain operating income (expense) is a part of NOPLAT, then its related asset (liability) should be included in invested capital. This ensures that the numerator and denominator are defined consistently.

Invested Capital = Operating Current Assets – Operating Current Liabilities + Net Property & Equipment – Cash

In the asset-based approach to calculating invested capital above, cash is netted out since interest income from cash is not included in operating income. When computing ROIC, the invested capital figure should come from the beginning of the accounting period or the average of the current and prior period.

2. Operating Leases and R&D Expense
Although operating leases do not show up on the balance sheet of a company, they create the same kind of obligation as debt. As a consequence, operating leases should be capitalized and financial ratios adjusted accordingly. (An overview of how to capitalize operating leases is covered in a separate post, here). In order to adjust ROIC for operating leases, the value of the leased asset must be added to invested capital in the denominator. Since invested capital is measured from the beginning (or middle) of the accounting period when calculating ROIC, the asset value of leases should similarly be from the previous year (or average of prior two) to maintain consistency. Additionally, operating income should be adjusted by adding back the operating lease expense and subtracting the pro forma depreciation on the leased asset. (The implied interest on the operating lease is ignored since ROIC measures operating income before interest).

Spending on R&D is expensed in the period in which it occurs rather than capitalized and amortized over time. Returns on capital, as a result, can be misleading if an analyst fails to account for the pro forma value of these intangible assets. (A summary on how to capitalize R&D expenses can be found elsewhere on this blog, here). To make the adjustment, the value of the research asset must be added to the book value of invested capital. Operating income is similarly adjusted by adding back the current R&D expense and subtracting the amortization of the implied research asset.

3. Goodwill
When assets are acquired as part of a business combination, a company records the acquired assets and liabilities at their estimated fair values. If the purchase price is greater than the sum of these market values, the excess is recorded as goodwill and is not amortized (though it can be impaired). Analysts commonly compute ROIC both with and without goodwill. Including goodwill in invested capital measures the performance of the company with its acquisition(s), whereas omitting it measures the company’s own internal performance.

A more effective way to account for goodwill is to include the majority of it in the calculation of invested capital, but exclude the portion that represents the value of “growth assets” (i.e. excess returns from expected future investments). This value can be approximated by measuring the difference between the market value of the target firm prior to the acquisition and the book value of the target firm. The value arrived at through this calculation should be subtracted from the goodwill amount that is added to invested capital. The remaining component of goodwill – the acquisition price over the market value prior to acquisition – is attributable to the expected synergies of the combination and/or any overpayment for the target firm. Since the acquiring firm is expected to generate income on this premium, it should be included in invested capital.

4. Extraordinary Items
Extraordinary items can often have the effect of skewing operating income and invested capital at companies. Writing off significant amounts of capital, for example, reduces invested capital, thereby causing a firm to report misleadingly high returns on capital. Extraordinary items that truly occur one time only (i.e. once every 10 years or longer) do not need to be adjusted and can simply be left out of analysis. Items that recur every year but represent gains in some years and losses in others, like foreign currency translations, can also be ignored since they are likely to have a neutral effect over time.

Expenses and income that seem to recur every year or at regular intervals suggest that such items are not truly extraordinary. The prudent thing to do in these cases is to treat the items as ordinary income or expense. Since the amounts of these kinds of items tend to be volatile on an annual basis, they should be averaged and spread out across time. Adjusting invested capital accordingly adds an extra layer of complexity. Impairment charges and one-time expenses reduce the amount of capital invested by the firm and therefore should be added back. This requires looking back through a large quantity of annual reports, especially for older firms.

5. Intercorporate Investments
Firms sometimes make equity investments in other companies, which can affect operating income and invested capital. The adjustments required when calculating ROIC depend on what type of return we’re interested in measuring and the type of investment that is made.

If the investor has no significant influence or control over operations of the investee (i.e. holds less than a 20% stake), the investment is considered a minority passive holding. Only dividends received from the investee are recorded in income. The book value of the investee on the balance sheet includes only the original investment.

If the parent company can exert significant influence but does not have control over the associate (i.e. holds a stake between 20% and 50%), the investment is considered a minority active interest. The investor’s portion of net income (or loss) from the associate is included in the income statement of the parent as an adjustment to net income. The book value includes the original investment plus any retained earnings from the investee. To remove the effect of minority holdings from ROIC, exclude the book value of the investment from invested capital. No adjustment is required to operating profits since earnings from the investee are not part of the investor’s operating income.

Business combinations in which the investor has control over the investee (i.e. stakes greater than 50%) are categorized as majority active interests. The parent company consolidates its own operations and that of its subsidiary on the income statement. Net income is then adjusted for the portion of the subsidiary owned by others, referred to as minority interests. The balance sheet of the parent includes an updated equity value for the holding and an adjustment for the portion of the company not owned by the parent company, again referred to as minority interests. Determining the ROIC for only the parent company requires subtracting the after-tax operating income of the subsidiary from the numerator as well as subtracting the book value of the subsidiary from the denominator. Note that deriving the return on capital for the parent in this way is an arduous process, especially when a firm has multiple holdings.

6. Estimate Future ROIC
The historical ROIC of a firm, even if measured correctly, may not be a good indicator of what returns will look like on future investments. A better measure is the return on new invested capital (RONIC), otherwise known as the marginal return on capital. RONIC is generally expected to be lower than ROIC since attractive investment opportunities decline over time as companies mature. Marginal returns will also be more volatile than average returns.

RONIC

In the long term (i.e. terminal period), returns on investments for individual companies should converge to industry averages or the cost of capital. This is not to say that companies cannot earn above-average ROICs for extended periods, but an analyst should carefully consider how long this can last. One of the most important functions of an analyst is to identify the source of the company’s advantage (or disadvantage) relative to its peers and determine whether it is sustainable given the competitive pressures of the industry.

The following average returns on invested capital by industry group come from McKinsey’s text, Valuation (2005, p. 148). Aswath Damodaran additionally provides a table of ROIC by industry online (here).

ROIC by Industry

A further way to analyze ROIC is to disaggregate it into its separate components, each of which measures a different driver of value. This analysis should reveal the competitive strategy of the company (e.g. high capital turnover indicates a production advantage whereas high operating margins denote a consumer advantage). These ratios can also be compared to the those of other companies in the same industry.

ROIC Components

Concluding Thoughts
For companies that disclose operating income and capital by segment, it is worth calculating ROIC for each business separately to gauge how efficiently the firm is allocating capital. Even if operating profit and invested capital are not explicitly given for each business, rough estimates can be determined by dividing company totals by the sales and assets of each division. If needed, use the equation below to convert back and forth between ROE and ROIC. ROIC is however considered a superior measure over ROE. The former focuses solely on a company’s operations and is unaffected by capital structure and share repurchases.

ROE = ROIC + [ROIC – (1 – T)kd](D / E), where kd is the cost of debt.

Many academic texts provide methods to adjust for taxes when calculating ROIC that go beyond using an effective tax rate. This is to ensure that the calculation of taxes is based only on operating income. The basic equation is provided below. Be sure to include the pro forma debt of operating leases when determining the tax shield on interest. (You will also need to subtract any taxes on non-operating income, such as restructuring charges).

Adjusted Taxes = Reported taxes – (Deferred taxest – Deferred taxest-1) + (Interest expense x Marginal tax rate)

Suggested Reading
Michael Mauboussin and Dan Callahan, CFA. Calculating Return on Invested Capital.

Aswath Damodaran. Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE).

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