In a previous article, Stanley explained the Return on Equity (ROE). While the ROE focuses on the equity component of a company’s capital investments, the Return on Invested Capital (ROIC) measures return earned on investments funded by equity and debt.
It shows how much profit a company generates for every dollar of investments it makes in the business. ROIC is expressed as a percentage and shown in the formula below:
Return on Invested Capital (ROIC) = After-tax Operating Income / (Book Value of Invested Capital)
where Invested Capital = Fixed Assets + Current Assets – Current Liabilities – Cash
We can calculate the ROIC using an example from Banyan Tree Holdings’ (SGX: B58) financial statement:
|Annual Report (SGD ‘000)||Fiscal Year 2012|
|Property, Plant and Equipment||729,558|
|Fiscal Year 2013|
|After-Tax Operating Income||29,951|
|Return on Invested Capital (ROIC)||4.1%|
*The high tax rate was due to the different geographic segments the company operates in
Based on the calculations above, we note that Banyan Tree generated an ROIC of 4.1% for FY2013. Do note that either an average of the past 2 years or the prior year’s book value of invested capital should be used.
Analyzing a firm’s ROIC is complementary to the ROE because it gives investors an idea whether a company has efficiently utilized both equity and debt financing. A company that generates excess returns over its cost of capital is earning is expected to trade at a premium over a firm which does not earn similar excess returns. An investor can measure how the company has fared over the past 5 to 10 years in its capital utilization and can also compare the ROIC between peer companies to have a better understanding of how each company utilized their capital investments.
Value in Action
ROIC is a good complement to the ROE. The ROIC measures an after-tax operating income of a company given its capital investments in its fixed assets and non-cash working capital (current assets – current liabilities – cash). A company which earns a return above its cost of capital is expected to trade at a premium over a firm which does not earn that same excess returns.
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All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie do not own any shares in the companies mentioned above.