Work out return on invested capital and explain what it reveals
The idea
Return on invested capital measures how much after-tax operating profit a business earns on all the capital provided by lenders and shareholders: ROIC = NOPAT / average invested capital, where NOPAT = EBIT x (1 - tax rate). Because it is measured before financing costs, it is not distorted by leverage the way return on equity is, which makes it the better guide to operating performance across firms. ROIC can be decomposed as after-tax operating margin times capital turnover. In capital allocation it is compared with the cost of capital: a spread above it creates value and a spread below destroys it. Economic profit, the spread times invested capital, shows how much value is created in absolute terms.
A practice question
Return on invested capital is best defined as:
- NOPAT / average invested capital — correct
- net income / shareholders' equityWhy not: That is return on equity, which depends on leverage and ignores capital provided by lenders.
- operating profit / total revenueWhy not: That is the operating margin, which measures profitability of sales, not of capital employed.
ROIC divides after-tax operating profit (NOPAT) by the capital provided by both debt and equity holders. It measures how efficiently the business turns invested capital into operating profit, independent of how that capital is financed.
A harder one
A company reports EBIT of 150, a 25% tax rate, and invested capital of 900 at the start and 1,100 at the end of the year. Its ROIC based on average invested capital is closest to:
- 15.00%Why not: This uses pre-tax EBIT; ROIC is based on after-tax operating profit.
- 10.23%Why not: This divides by ending invested capital rather than the average for the year.
- 11.25% — correct
NOPAT = 150 x (1 - 0.25) = 112.5. Average invested capital = (900 + 1,100)/2 = 1,000. ROIC = 112.5/1,000 = 11.25%.
The hardest tier
Division A has invested capital of 200, ROIC of 14% and a cost of capital of 10%. Division B has invested capital of 1,000, ROIC of 9% and a cost of capital of 8%. Which creates more economic profit?
- Division A, with its higher ROICWhy not: A higher ROIC spread does not mean more value created; the spread must be applied to the capital invested.
- Neither, since both earn the sameWhy not: The two divisions create different amounts once each spread is multiplied by its capital base.
- Division B, with 10 versus 8 — correct
Economic profit = (ROIC - cost of capital) x invested capital. A: 4% x 200 = 8. B: 1% x 1,000 = 10. B creates more value in absolute terms, although A earns the wider spread per unit of capital.
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