ROIC for dummies via Value Edge
An introduction into Return on Invested Capital (ROIC) for those who are unfamiliar with it (including me). ROIC measures how efficiently a company uses its capital and we have covered previously how growth may not always be good for a company. To generate returns, a company has to raise and invest in assets and such capital incurs cost (both direct and indirect). Value is only created when these returns exceed the cost of capital and one way to measure these returns is through ROIC.
After-tax operating income
Operating income is used as the ROIC measures the returns on all capital (both debt and capital). Comparatively, net income measures only the return to equity investors as it is net of interest expenses. However, operating income is not a typical line item included in your income statement. There are 2 ways in arriving at this numerator.
1) After tax operating income = EBIT (1 – tax rate)
Do take note that this is not equivalent to subtracting the actual taxes paid/tax expense in your financial statement as that value includes savings from your interest tax shield.
2) After-tax operating income = Net Income + Interest Expenses (1- tax rate) – Non-operating income (1 – tax rate)
Invested Capital = Total assets – Cash – Non-interesting bearing liabilities
Book values are used for these accounts and no revisions are needed. Cash is deducted to be consistent with our definition of operating income which does not include interest income. This ensures that companies with substantial cash holdings are not penalized as cash generally have low returns. More importantly, it does not reflect the efficiency of a company’s business operations and should not be included in both in the numerator (in the form of returns) and the denominator. Similarly, non-interesting bearing liabilities such as accounts payables represent capital invested by the company’s suppliers, not the company itself. Lastly, while operating income is based on the current year figures (end of year), these book values based on start-of-year figures (essentially the preceding year). The rationale is that investments made during the year will not immediately start generating earnings during the year.
To determine if a firm is value-creating, we compare the ROIC with the cost of capital (WACC). A firm with ROIC higher than WACC would be value-creating and vice versa. How does the ROIC compare with the ROE? As the names suggest, ROIC measures the return on all capital (both debt and equity) while ROE measures only the return on equity. Consequently, an alternative way of determining if a firm is value-creating is by comparing ROE with the cost of equity.
Most of the information here is from Damodaran’s 69-page paper on Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications. You can read the full paper here. We have only covered the very basics of the topic and the paper dwells much deeper into the intricacies between the different measurements (such as cash vs accounting returns) which we may cover another day.