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ROIC: return on invested capital

What ROIC measures, how to calculate it from an annual report, the usual thresholds by investor profile, the traps worth knowing and the sectors where it does not apply.

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Definition

ROIC (return on invested capital) divides after-tax operating profit by the capital the company uses to generate it: its equity and its net financial debt. It shows how much the business earns for each euro committed, whatever the way that capital is financed.

Formula

ROIC = operating profit × (1 − tax rate) / (equity + net financial debt)

Where to find it in an annual report

Operating profit is in the income statement. The effective tax rate appears in the note on income tax. Equity, borrowings and cash are on the balance sheet. To smooth out variations, the average of invested capital between the start and the end of the financial year is often used.

Common thresholds

ROIC durably above 15% is the sign of a very profitable business. Between 10 and 15%, it remains decent for most sectors. Below 10%, it barely covers the cost of capital for many companies. Consistency over 5 to 10 years matters more than a single year.

In the preset strategies

Preset strategy Criterion met To monitor Criterion not met
Long-term quality Average ROIC (5 to 10 years) ≥ 15% 10% to 15% < 10%

Pitfalls

  • An exceptional year (sale of a division, reversal of a provision) inflates profit: look at the average over several financial years.
  • Large share buybacks or past losses reduce equity and push ROIC up without the business improving.
  • Invested capital changes a lot depending on whether goodwill is kept or not: use the same method from one year and one company to the next.
  • Data sources do not all use the same formula: compare figures taken from the same source.

Where it does not apply

  • Banks and insurers: their debt is part of the business itself. Return on equity and price to book are better suited.
  • Real estate companies: the value of buildings on the balance sheet and unrealized gains distort invested capital.
  • Young companies that are still loss-making: the ratio is negative and says nothing about their future profitability.

A worked example

Take a fictitious company, called Company A here. Its operating profit is €120 million and its effective tax rate 25%. Its equity amounts to €450 million and its net financial debt to €150 million.

Its after-tax operating profit is 120 × 0.75 = €90 million, for invested capital of 450 + 150 = €600 million. Its ROIC is therefore 90 / 600 = 15%.

ROIC and return on equity

Return on equity (ROE) only looks at shareholders’ money. A heavily indebted company can show a high ROE with a business that is not very profitable. ROIC counts debt in invested capital: it judges the business itself, before the way it is financed.

Sources