Return on Invested Capital (ROIC)

Overview

Return on Invested Capital is an efficiency ratio that measures how well the management of the company is allocating capital in order to improve profitability and produce growth. ROIC takes into account the costs of investments and the returns those investments have generated over a particular time frame.

Return on invested capital can also be used as a proxy to determine if a company has some kind of competitive advantage (moat). As an efficiency ratio, the higher the ratio, the more efficient the company is at allocating capital.

Formula

Where Invested Capital is calculated as:

Components: For returns, we usually use EBIT that is representative of the company's profit, including all expenses except interest and tax expenses. Some versions of the formula use Net Income with interest expenses added back: NOPAT = (Operating Profit) × (1 − Tax Rate).

For the invested capital, there are a few different formulas depending on the analyst and the capital structure of the company. We exclude cash as usually the cash is not actually invested into the business and not part of the actual business operations. We also exclude (non-interest bearing) current liabilities like accounts payable and different taxes since these are also not an active part of the company's operations.

Calculation Example

Let's calculate the return on invested capital for a hypothetical company to demonstrate the process:

How to Interpret

Since ROIC is an efficiency ratio, the higher the ratio, the more efficient the company is at allocating capital. Typically, if a company can maintain return on invested capital higher than 15% for a substantial number of years, it is usually a sign that the company has some kind of competitive advantage over their peers.

General Guidelines:

Why It Matters

ROIC is an important metric that many investors and business analysts use to assess the quality of a business. ROIC focuses on two important parts of the business that are critical for long-term success.

Key Insights:

• Capital Allocation Effectiveness: First, ROIC shows how good management is at allocating capital and generating profitability. It measures whether the company is deploying invested capital efficiently to improve profitability and produce growth. This reveals management's effectiveness at making capital deployment decisions that create value.
• Competitive Advantage Indicator: Second, many investors use ROIC as a proxy for determining if a company has some kind of competitive advantage (moat). Sustained high ROIC over many years is typically a sign of durable competitive advantages that protect the business from competition.
• Business Longevity Assessment: Having a competitive advantage is important in order to determine whether the business can stand the test of time. ROIC helps investors evaluate if the company has structural advantages that will allow it to maintain its market position over long periods.
• Profit Margin Sustainability: ROIC reveals whether the company can keep or even increase its profit margins over a certain period of time. Companies with high ROIC typically have pricing power, cost advantages, or other moats that enable them to maintain or expand margins even in competitive environments.
• Quality Business Identifier: Investors and business analysts use ROIC to assess the quality of a business overall. High ROIC signals a quality business with efficient operations, strong competitive positioning, and effective management—all characteristics that contribute to long-term shareholder value creation.

Key Takeaways

• Return on Invested Capital is an efficiency ratio measuring how well management allocates capital to improve profitability and produce growth
• Takes into account the costs of investments and the returns those investments have generated over a particular time frame
• Can be used as a proxy to determine if a company has some kind of competitive advantage (moat)
• Formula: ROIC = EBIT ÷ Invested Capital, where Invested Capital = Debt + Assets − (Intangibles − Cash − Current Liabilities)
• Uses EBIT (or sometimes NOPAT) to measure returns, representing company profit including all expenses except interest and taxes
• Excludes cash (not invested in business operations) and non-interest bearing current liabilities (accounts payable, taxes) from invested capital
• Since ROIC is an efficiency ratio, higher ratios indicate more efficient capital allocation by management
• ROIC above 15% maintained for substantial years typically indicates company has competitive advantage over peers
• Important metric that investors and business analysts use to assess the quality of a business
• Focuses on two critical aspects: management capital allocation effectiveness and competitive advantage indicators
• Helps determine if business can stand the test of time and keep or increase profit margins over time
• High sustained ROIC is one of the strongest indicators of durable economic moat and long-term shareholder value creation