While ROIC and ROI may seem like similar financial abbreviations on the surface, the main difference between each metric lies in the purposes for which they are being used. ROIC measures the return of a business based on its invested capital, usually on an annualized or trailing 12-month basis. ROI on the other hand, purely expresses the return on one single investment based on cash flow, and is not defined by a specific time frame.
ROIC vs ROI: What's the Difference?
Simply put, ROIC is an accounting measure that gives investors a clue on how efficiently companies are operating, whereas ROI shows how well an investment, project, or strategy has turned out to be.
Consequently, ROI is a rather generic metric that can be used to compare the efficiency of different investments with each other. Investors may use ROI to compare individual stock performances, companies might calculate the ROI of a given project to determine whether it is lucrative or not, whereas marketers can use the ROI measure as an assessment of how effective a marketing campaign has turned out to be.
The return on invested capital, on the other hand, reveals the percentage return on the actively-used capital that has been invested within a company. It is, therefore, purely used to evaluate a company’s ability at allocating its capital.
Investors, for example, can compare ROICs of similar companies that are operating within the same industry to determine which business is essentially running at a more efficient level.
Primarily, ROIC is compared with the weighted average cost of capital (WACC) to assess whether a firm is either creating value or destroying value. If a company’S ROIC is higher than its corresponding WACC, the company is creating excess value, whereas a negative difference between ROIC and WACC concludes that the business is destroying shareholder value.
Another practical purpose of an accounting measure like ROIC is its use in valuation, where the expected growth of a business is a function of the return and reinvestment rate. Analyzing and estimating the return on capital for a company is essential because it plays one of the key determinants for future growth.
ROIC vs ROI: Calculation
Both metrics are similar in the regard that they represent the return based upon a corresponding denominator.
Return on Investment
In order to calculate the ROI you need
- The current value of the investment that you are measuring
- The initial cost of that investment
The return on investment represents the difference between the final value and initial cost divided by cost:
ROI is a percentage rate that can be further be used to compare different investments or projects with each other. A positive ROI implies that the investment is profitable, meaning that it is returning positive cash flow.
Let’s suppose that we’ve invested in stock XYZ one year ago, paying an initial cost of $135 for one share. The stock price has risen to $182 now and we want to figure out how well that stock has performed until today. What we could do is calculate the ROI for the stock using the formula above which would go as follows: ($182 – $135) / $135 = 34,8%.
As a result, the return that we get from our investment if we sell the stock right now would be 34,8%. With this information, we could now compare that performance with other investments, given the premise that we choose the same investment time frame for proper comparison. Otherwise, we could also take the average annual return (CAGR) of different investments to properly compare those with each other.
Return on Invested Capital
The formula of ROIC goes as follows:
ROC is a more comprehensive metric to calculate than ROI because it is purely used as a measurement for the efficiency of a company’s allocated capital.
In order to calculate the ROIC of a company for a given time period, we need its operating income figure after taxes, which is defined as EBIT x (1 – Tax rate). Then, we would have to divide that number by the company’s invested capital which is defined as the book value of the total debt plus equity minus cash & cash equivalents.
As an example, a company with an after-tax operating income of $35 million and total invested capital of $175 million would have an ROIC of 20%
Please note that the ROIC figure of companies can also be negative when the book value of equity is negative, or when companies have cash balances exceeding total equity and debt. In that case, the negative ROIC figure is not going to give a meaningful picture of a company’s efficiency.
In comparison, both ROIC and ROI are similar in the regard that they try to measure profitability/efficiency, either on a given project or a whole business. ROI is a more generic metric that purely serves the purpose of expressing the gains on an investment or a project, making it a performance measure that can primarily be used to compare different investments with each other.
ROIC particularly focuses on the efficiency of a firm in allocating its total invested capital. A company’s ROIC can only be compared with its own cost of capital or the ROIC of other similar businesses that are operating within the same industry in order to draw sensible conclusions. One additional thing to note is that both the terms return on invested capital (ROIC) and return on capital (ROC) represent the same metric.