ROIC – Return on Invested Capital

What is Return on Invested Capital (ROIC)?

Return on Capital Invested Capital (ROIC) is one of the profitability ratios that help us understand how the firm is using its invested capitalInvested CapitalInvested Capital is the total money that a firm raises by issuing debt to bond holders and securities to equity shareholders. Invested Capital Formula = Total Debt (Including Capital lease) + Total Equity & Equivalent Equity Investments + Non-Operating Cash read more i.e., equity and debt, generating profit at the end of the day. The reason this ratio is so very important for investors before the investment is because this ratio gives them an idea about which company to invest in. Because the percentage of profits generated from the invested capital is a direct ratio of how good a company is doing in terms of transforming its capital into income.

While calculating this ratio, one thing you need to remember is that whether you are taking the core income of the business (i.e., most of the time, “net income” of the firm) as a measuring grid. The business can generate incomes from other sources, but if it’s not from their core operations, it shouldn’t be taken into account.

ROIC of Home Depot shows an upward trend and currently stands at 25.89%. What does this mean for the company, and how it impacts the decision-making process of the investors?

Home Depot ROIC 1

ROIC Formula

ROIC Formula = (Net Income – Dividend) / (Debt + Equity)

Let’s take each item from the equation and explain in a brief manner what they are.

As a business or as an investor, if you want to calculate this ratio, the first thing you need to take into account is Net Income. This Net Income should be coming from the main operations of the business. That means “Gains from foreign currency transactions” or Gains from other currency transactions” wouldn’t be included in Net Income.

If you find that there are too many incomes from other sources, calculate the Net Operating Profit after Tax (NOPAT). You won’t find NOPAT in the financial statements, but you can calculate it by following this simple formula –

Also, have a look at the Ratio analysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.read more Guide.

NOPAT Formula = Operating Income before Tax * (1 – Tax)

Now how would you get the figure of Operating Income? To find out operating income, you need to look into the income statement and would find out the operating profit or operating income. Let’s understand this with an ROIC example –

  In US $
Gross Revenue 50,00,000
(-) Direct Costs (12,00,000)
Gross Margin (A) 38,00,000
Rent 700,000
(+) General & Administration Expenses 650,000
Total Expenses (B) 13,50,000
Operating Income before tax [(A) – (B)] 24,50,000
  • To calculate NOPAT, all you need to do is to deduct the tax proportion from the Operating Income.
  • In the case of Dividend, if you have paid any dividend during the year, you need to deduct that from Net Income.
  • Debt is what the firm has borrowed from a financial institution or banks, and equity is what the firm has sourced from equity shareholders.

Interpretation

As from the explanation, you may have understood that Return on Capital is not an easy ratio to calculate. But irrespective of all these complexities, if you can come up with Return on Capital, it would help a great deal in deciding how the company is doing. Here’s why –

  • It includes most of the things into account while calculating the ratio. You are taking into account net income or NOPAT and also how much capital the business has invested. So it produces the right percentage of the profit at the end of the year.
  • This ratio emphasizes more on the income from operations and doesn’t always include other income. That means it’s the purest form of calculation to ascertain the profit percentage.

Return on Invested Capital Example

  In US $
Net Income 300,000
Shareholders’ Equity 500,000
Debt 10,00,000
Shareholders’ Equity 500,000
Debt 10,00,000
Invested Capital 15,00,000
Net Income 300,000
(-) Dividend
Invested Capital 15,00,000
Return on Capital 20%

If you find the ROIC of a company more than 20% for the last few years, you may think about investing in the company, but make sure that you take into account every figure and detail while calculating this ratio.

ROIC Calculation for Infosys

We will look at the income statement and balance sheet of Infosys for the year-end 2014 and 2015 and then will calculate the ROIC ratio for both the years.

Let’s have a look at the Balance Sheet first.

Balance Sheet as at 31st March 2014 & 2015 –

Infosys Balance Sheet ROIC Calculation

source: Infosys Annual Report

Statement for profit and loss for the year ended 31st March 2014 & 2015 –

Infosys Net Income ROIC Calculation

source: Infosys Annual Report

Now, let’s calculate the return on invested capital.

In Rupees Crores 31st March 2015 31st March 2014
Profit for the year (A) 12164 10194
Capital Invested (B) 48068 42092
Return on Capital 0.25 0.24
Return on Capital (in percentages) 25% 24%
  • As there is a negligible amount of other income, we took the whole income into account while coming up with the profit of the year. And also, there is no dividend mentioned, so we didn’t deduct the amount from the profit.
  • As Infosys is a fully debt-free company, only shareholders’ funds are considered to be capital invested.

If we come to interpret the Return on the Invested Capital ratio for both of the years, we could easily say that Infosys is a company that has been successful in generating a great Return on Capital for both of the years. So from the point of view of the investors, Infosys may seem a good place to invest their money into.

Why Home Depot’s Return on Invested Capital is Increasing?

Home Depot is a retail supplier of home improvement tools, construction products, and services. It operates in the US, Canada, and Mexico.

When we look at Home Depot’s ratio, we see Return on Capital of Home Depot has climbed up steeply since 2010 and is currently at 25.89%.

What are the reasons for such an increase?

Home Depot ROIC 1

source: ycharts

Let us investigate and find out the reasons.

Return on Invested Capital ratio can increases either because of an increase in 1) Net Income 2) decrease in Equity 3) Decrease in Debt

# 1 – EVALUATING HOME DEPOT’S Net Income

Home Depot increased its Net Income from $2.26 billion to $7.00 billion, an increase of approximately 210% in 6 years. This significantly increased the numerator and is one of the most important contributors to the uptick in ROIC ratio

Home Depot Net Income

source: ycharts

#2 – EVALUATING HOME DEPOT’S SHAREHOLDER’S EQUITY

We note that shareholder’s equity of Home Depot has decreased by 65% in the last 4 years. Declining shareholder’s equity has contributed to the decrease in the denominator of the ROIC ratio. With this, we note that the decrease in Shareholder’s Equity has also contributed meaningfully to the increase in Home Depot ratio

Home Depot Equity Decrease - Equity Turnover Ratio

source: ycharts

If we look at Home Depot’s Shareholder’s Equity section, we find the possible reasons for such a decrease.

Home Depot - Equity Decrease

  1. Accumulated Other Comprehensive Loss has resulted in the lowering of shareholders’ equity in both 2015 and 2016.
  2. Accelerated BuybacksAccelerated BuybacksAccelerated share repurchase (buyback) is a strategy adopted by a publicly-traded company to acquire its outstanding shares in the market from the clients in large blocks via an investment bank.read more were the second and most important reason for the decrease in Shareholder’s equity in 2015 and 2016.

#3 – Evaluating Home Depot Debt

Let us now look at Home Depot’s Debt. We note that Home Depot debt increased from 9.682 billion in 2010 to $21.32 billion in 2016. This 120% increase in debt resulted in a lowering of the ROIC ratio.

Home Depot ROIC - Increase in Debt

source: ycharts

Summary –

We note that Home Depot’s Return on Invested Capital ratio increased from 12.96% in 2010 to 25.89% in 2016 because of the following –

  1. Net Income increased by 210% in the period from 2010-2016 (a major contributor to the numerator)
  2. Shareholder Equity decreased by 65% in the corresponding period. (a major contributor to the denominator)
  3. An overall increase in the ROIC ratio because of the two factors above (1 and 2) was offset by the 120% increase in debt in the corresponding period.

Industry-wise ROIC Ratios

What is the right benchmark for a great ratio? The answer is it depends!

It depends on the kind of industry it operates into. We can’t compare Amazon’s ratio with that of Home Depot as they operate in a totally different sector.

Below we have documented some industry Return on an Invested Capital ratio that will help you with the ballpark figures of what seems to be a good ROIC ratio.

Two important points to note here –

  • Capital Intensive Sectors like Telecom, Automobile, Oil & Gas, Utilities, Departmental Stores tend to generate low ROIC
  • Pharmaceutical, Internet Companies, Software Application companies tend to generate higher Return on an Invested Capital ratio

Let us have a look at some of the top companies in some important sectors. Please note that the source of Industry Return on the Invested Capital ratio is ycharts.

Departmental Stores Industry Example

S. No Name Return on the Invested Capital  ratio (Annual) Market Cap
1 Macy’s 8.7%         9,958.7
2 Cencosud 3.2%         8,698.1
3 Nordstrom 13.0%         7,689.5
4 Kohl’s 7.9%         7,295.4
5 Companhia Brasileira 1.1%         4,900.7
6 JC Penney Co -7.7%         2,164.3
7 Dillard’s 9.9%         1,929.0
8 Sears Holdings -58.6%             685.0
9 Sears Hometown and Outlet -5.6%               86.3
10 Bon-Ton Stores -6.2%               24.4
  • We note the following in the example of the Internet and content industry. We note that Nordstorm has an ROIC ratio of 13%; on the other hand, Macy’s has a ratio of 8.7%
  • Many companies like Sears Holding, Bon-Ton Stores, JC Penney Co show a negative Return on Invested Capital ratio.

Internet and Content Industry Example

Symbol Name Return on the Invested Capital ratio (Annual) Market Cap ($ Million)
1 Alphabet 15%           580,074
2 Facebook 20%           387,402
3 Baidu 35%              63,939
4 Yahoo! -12%              43,374
5 JD.com -25%              41,933
6 NetEase 24%              34,287
7 Twitter -8%              11,303
8 VeriSign 60%                8,546
9 Yandex 11%                7,392
10 IAC/InterActive -1%                5,996
  • Internet and Content companies are generally not capital intensive like the Utilities or Energy Companies. Therefore, we can see that the Return on an Invested Capital ratio of this industry is higher.
  • Alphabet, Facebook, and Baidu have a ratio of 15%, 20%, and 35%, respectively.
  • Yahoo, JD.Com, and Twitter, however, have a negative Return on Invested Capital.

Telecom Industry Example

Please see below the list of top Telecom Companies in the US, along with ROIC calculation and Market Capitalization.

S. No Name Return on the Invested Capital  ratio (Annual) Market Cap ($ million)
1 AT&T 5%                               249,632
2 China Mobile 12%                               235,018
3 Verizon Communications 10%                               197,921
4 NTT DOCOMO 9%                                  88,688
5 Nippon Telegraph 5%                                  87,401
6 Vodafone Group -4%                                  66,370
7 T-Mobile US 2%                                  50,183
8 Telefonica 1%                                  47,861
9 American Tower 3%                                  45,789
10 America Movil 1%                                  42,387

We note the following in the ROIC Example of the Telecom industry.

  • We note that the Telecom sector is a capital intensive sector, and its Return on the Invested Capital ratio is on the lower side.
  • AT&T, China Mobile, and Verizon have a ratio of 5%, 12%, and 10%, respectively.
  • Vodafone Group, on the other hand, have a negative ratio of -4%

Oil & Gas E&P Industry Example

S. No Name Return on the Invested Capital ratio (Annual) Market Cap ($ million)
1 ConocoPhillips -6%                                  61,580
2 EOG Resources -21%                                  57,848
3 CNOOC 4%                                  55,617
4 Occidental Petroleum -2%                                  51,499
5 Anadarko Petroleum -10%                                  38,084
6 Pioneer Natural Resources -4%                                  33,442
7 Canadian Natural -1%                                  33,068
8 Devon Energy -47%                                  23,698
9 Apache -88%                                  21,696
10 Concho Resources 1%                                  20,776
  • We note that the Oil & Gas sector is a highly capital intensive sector and has a lower ROIC ratio.
  • A slowdown in the Oil & Gas sector since 2013 has led to declining profitability and losses in most cases.
  • From these top Oil & Gas companies, 8 companies have a negative ratio.
  • Only two companies, namely, CNOOC and Concho resources, have a positive Ratio of 4% and 1%, respectively.

Automobile Industry Example

S. No Name Return on the Invested Capital  ratio (Annual) Market Cap ($ million)
1 Toyota Motor 6%                               170,527
2 Honda Motor Co 2%                                  57,907
3 General Motors 8%                                  53,208
4 Ford Motor 3%                                  49,917
5 Tesla -25%                                  45,201
6 Tata Motors 7%                                  25,413
7 Fiat Chrysler Automobiles 1%                                  18,576
8 Ferrari 10%                                  16,239
  • Again, the Automobile Sector is highly capital intensive, and we note that most companies show a lower ROIC ratio.
  • Toyota Motors, Honda Motor, and General Motors have a ratio of 6%, 2%, and 8%, respectively.
  • Tesla, on the other hand, has a negative ratio of -25%

Utilities Industry Example

S. No Name Return on the Invested Capital ratio (Annual) Market Cap ($ million)
1 National Grid 6.8%                                  47,002
2 Dominion Resources 4.7%                                  46,210
3 Exelon 1.9%                                  46,034
4 Dominion Resources 4.7%                                  31,413
5 Sempra Energy 5.0%                                  26,296
6 Public Service Enterprise 7.6%                                  22,138
7 FirstEnergy 1.7%                                  13,012
8 Entergy -0.7%                                  12,890
9 Huaneng Power 5.4%                                  10,522
10 AES 2.6%                                    7,699
  • As pointed out earlier, Utilities are also capital intensive sector and has a lower ROIC ratio.
  • National Grid, Dominion Resources, and Exelon has a ratio of 6.8%, 4.7%, and 1.9%, respectively.
  • Entergy, on the other hand, has a negative ratio of -0.7%

Limitations

Return on Invested Capital (ROIC) Video

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In the final analysis

After discussing everything in detail, we come to the conclusion that ROIC is a great ratio to calculate if you want to know how a firm is doing in a real sense. If Return on Invested Capital ratio can be followed over the years, it would certainly give a clear picture of how a firm is doing. Thus, if as an investor, you want to invest your money into a firm, calculate Return on Invested Capital first and then decide whether it’s a good bet for you or not.