The return on invested capital (ROIC) is one of the core fundamental return metrics that are used use to assess the efficiency of a company. Throughout the last decades, more and more investors, analysts and managers have developed a strong emphasis on ROIC, as it has proven to be one of the primary factors that drive the value of a business.
ROIC is such of importance because it directly reflects the return of investments that a company’s management decides to execute. Furthermore, it is a figure that’s difficult manipuilate unlike other financial metrics such as ROE, EPS, or EBITDA.
Return on Invested capital can also be viewed as a strong indicator of how effective the management of a company operates within a business. Increased and sustainable returns on capital essentially translate to higher amounts of cash flows that shareholders get to keep at the end of the day.
In summary, there is a strong link between ROIC and the quality and future prospects of a business. So how we assess a company’s return on invested capital and what makes a good ROIC?
What Is Return on Invested Capital?
The return on invested capital is a basically a percentage metric that represents the return of all the capital that is currently invested within a business. The ROIC of a company can be calculated by dividing the net operating profit after taxes by its invested capital.
To calculate ROIC, take the operating income after taxes defined as EBIT x (1 – Tax rate) and divide that number with the invested capital of the business which is defined as the sum of equity and debt minus cash.
This formula is probably the most widely known way of computing general ROIC and also the most intuitive definition in my opinion. However, please note that some companies that do analyze their ROIC, may calculate their own metric in a slightly different way than how it is generally defined. Therefore, it can be beneficial to look up in their reports how they arrive at their ROIC if you use their number for further analysis.
What’s a Good Return on Invested Capital?
The short answer: Any return on invested capital of a firm that is greater than its corresponding cost of capital (WACC) would be considered a good ROIC. In other words, if the return of a company’s investments exceeds the cost to fund those investments in the first place, the company is essentially creating excess value. On the other hand, if ROIC is lower than the WACC, the business is destroying value.
Generally speaking, the higher the return on invested capital relative to its cost of capital, the more efficient a business is being able run its operations. That being said, from an investor’s perspective, a great ROIC is not giving us the full picture because it won’t help much if we don’t understand how a firm’s performance currently holds itself against expectations. This is why ROIC needs to be analyzed in comparison with its own business standards and other benchmarks such as competitors and peers within the same industry.
One way to assess a good ROIC is by comparing it with the company’s weighted average cost of capital (WACC), which represents the average cost to finance its capital.
As an example, let’s look at PepsiCo (PEP). The company had an annual ROIC of 10,68% for 2020. Its WACC for the same year was 4,77%, meaning that PepsiCo generated higher returns on its investments than the costs of capital for those investments.
The beverage company managed to provide excessive returns for the past decades, leading to increasing value along with steady growth, which is also reflected well in the stock price.
You can also get a sense of how good a company’s ROIC is by comparing it directly with other companies or industry averages. Different industries will have different standards of ROIC. For example, an advertising business is likely to have a substantially higher ROIC than a chemical company because of its less capital-intensive business model. This is why it only makes sense to compare ROICs of similar businesses that are operating within the same industry.
Monster Beverage (MNST) also operates within the soft beverage industry. It’s not as big and mature as its blue-chip rival but the company provides a history of pretty good ROICs. For the year 2020, the business had an annual ROIC of 42% and a WACC of 8,31%.
The consistently above-average return on invested capital played a key role in the incredible growth of the business over the past years.
In order to help you get a better picture of ROIC standards for individual companies, here is a list of average ROICs across many different industry sectors in the U.S. which should be regularly updated. As of January 2021, the total market average ROIC is 6,05%, without the financial companies, it is 10,58%.
It’s also interesting to see how much ROIC numbers can vary from industry to industry. Many sectors have an average ROIC in the low to mid-teens, while some either offer much lower, or exceptionally higher ROICs.
That’s why it’s important to always look at the return on invested capital from a general perspective and evaluate if the number is appropriate for the type of business.
What Does a Good Roic Mean?
In general, the spread between a company’s ROIC and WACC will decrease over time, as other businesses will enter the market and try to compete for higher returns. This is why an economic moat is essential for a business to sustain high returns in the long run.
“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”
An economic moat is the ability of a business to maintain a competitive advantage over its competitors which will keep them from taking market share and allows the business to have high profits over long time periods. Typical moats include, for example, high barriers to entry, cost advantages, patents, or high customer switching costs.
Companies that are able to consistently provide higher ROIC than their WACC are likely to have an economic moat and continue growing. So if you’re analyzing a business and you suspect that it might have an economic moat, you should check its history of ROICs to see if the numbers confirm your assumption.
Good capital allocation is one of the most important skills that business leaders need to master. The truth is that not every management cares enough about this objective.
Therefore, it’s necessary to assess the ability of a company’s management in order to know how efficient the business is ran by its leaders. The results of a great management should mostly show up in the history ROICs. When you see a long record of high return on invested capital relative to WACC, that’s a good sign for effective management.
Conclusion
The return on invested capital is a useful metric that can be used as a tool to measure the effectiveness of a company’s allocated capital and also reflect the performance of a firm’s management. There are several different ways to calculate and adjust the ROIC of a business, which would depend on the type of business model and individual preferences from the investor.
Comparing a company’s ROIC with its cost of capital will give you a good picture of the general effectiveness and quality of the business. A history of consistently high ROIC figures indicates that the business has established a strong economic moat and is likely to continue with steadily growing value in the future.
That being said, just like any other financial metric, making investment decisions solely based on the ROIC of a company won’t be enough since there are many other factors that have to be taken into consideration. However, an attractive ROIC is still one of the key metrics that every investor who is looking for high-quality stocks should find in a business.
