Simplifying Return On Invested Capital

  • Return on invested capital or ROIC gives a clear picture as to how well a firm is using capital in profitable investments.
  • ROIC is an important metric for a value investor and as it helps determine a company's moat.
  • ROIC is useful for companies that invest a large amount of capital, like computer hardware companies, and oil and gas firms.

We have often mentioned why we love Priceline (NASDAQ:PCLN). One of the prime reasons we see Priceline as a long term bull play is due to the attractive ROIC it generates. If you are wondering what is ROIC, then you are on the right page. We shall today continue our series of articles aimed at helping individual investors understand finance and become better investors. Following up our recent article on understanding WACC (Weighted cost of capital), we shall today focus on one of the most important ratios to calculate business efficiency, ROIC a.k.a return on invested capital.

ROIC (Return on invested Capital)

Put simply, ROIC is the returns/profits generated on the total invested capital. It is calculated as:

ROIC = Net operating profit after tax (NOPAT)/Invested Capital

The numerator is self-explanatory and reflects the operating profit without adjusting for interest expenses. We use the NOPAT rather than the Net Income as the NOPAT is a better measure of the underlying operating efficiency of a firm. The NOPAT, in the simplest sense is the Operating Income*(1-tax rate). The operating income is a line item appearing on the Income statement reported by most companies in forms 10-Q and 10-K.

On a cautionary note, the NOPAT calculation can require many adjustments depending on the accounting policies adopted by a firm. The main idea of the various adjustments is to get a NOPAT number that more closely reflects the cash operating profits and has a consistency with the method used to calculate the denominator; Invested Capital.

We shall now move on to understand the denominator: Invested Capital.

Invested Capital is calculated as:

Invested Capital = Total Assets - Cash - Non interest bearing current liabilities

The invested capital is the total capital invested in the business and which comes at a cost to the company. To understand invested capital let’s look at a typical company balance-sheet and calculate the invested capital.

Assets Liabilities
Cash Short term debt
Accounts receivable Accounts payable
Inventory Advances
Other current assets Other current liabilities
Total current assets Total current liabilities
Investments Long term debt
Goodwill Common stock
Intangibles Additional paid in capital
Property plant & equipment Retained Earnings
Other long term assets Minority interest
Total long term assets Shareholder's equity
Total assets Total liabilities

The above balance sheet is a representative balance sheet including the various line items typically found in a company balance sheet. The invested capital is the sum of the line items highlighted in yellow. The same can be expressed using the following formula:

Invested Capital = Short-term debt + Long term debt + Shareholder’s equity - Cash balance

Another alternative formula to calculate the invested capital is:

Invested Capital = Total Assets - Cash - Accounts payable - Advances - Other Current Liabilities

As stated earlier there has to be a consistency between the methods adopted for NOPAT and Invested capital calculations. The consistency assumes greater importance in the case of operating expenses which result from off balance sheet financing and also adjustments with respect to the Minority interest. An adjustment in the NOPAT must be reflected by a parallel adjustment in the Invested Capital calculation in order to generate a more accurate measure of ROIC.

ROE (Return on Equity)

ROE or return on equity is simpler to understand and calculate as compared the ROIC. ROE is measured as the Net Income generated divided by the book value of equity. However the ROE is a number which is based on portion of profits attributable to the ownership interests, excluding the share of profits attributable to debt holders. Therefore it can change drastically based on a change in the capital structure, without any significant change in the underlying operations. ROE can be calculated using the following formula:

ROE = Net Income/Shareholder’s equity

ROE is easier to calculate as it is based on numbers reported as line items in the company filings with the SEC. However ROIC is a better measure of the operating efficiency although it is a derived value and hence a bit more difficult to calculate.

Difference between ROE and ROIC

The ROE measures the returns to owners or shareholders while the ROIC measures the returns to all providers of capital. The ROIC measures the efficiency of a business and is comparable across firms irrespective of the Capital structure or degree of financial leverage employed. On the other hand, RIE is a measure which is hugely distorted by the capital structure involved. All other factors being constant, a firm with a higher leverage will have a higher ROE and vice-versa.

Understand ROE and ROIC: Priceline, an example

Let’s look at Priceline as an example to better understand the difference between ROIC and ROE

In millions of $, except percentages 2012-12 2013-03 2013-06 2013-09
Total Capital 6569.7 6855.1 9867.4 10445.7
Cash & Cash Equivalents 5183.2 5181.6 5945.1 6583.6
Non interest bearing current liabilities 941.38 1079.11 1239.23 1287.58
Shareholders Equity 3896.97 3990.84 5957.66 6396.62
Pretax Income 356.02 290.44 535.56 1020.35
Tax 66.43 46.15 98.12 187.36
Income after Tax 289.59 244.29 437.44 832.99
Tax rate 18.7% 15.9% 18.3% 18.4%
Net Income 288.66 244.27 437.33 832.99
Operating Income 374.31 309.84 554.83 1046.9
NOPAT 304.47 260.61 453.18 854.66
LTM NOPAT 1872.92
Invested Capital 1574.3
Return on Invested Capital (ROIC) 119%
Return on Equity (ROE) 35.8%

The ROE and ROIC is calculated using the formulas discussed above. Priceline employs a highly efficient business model as is illustrated by its ROIC. The company has also historically provided high returns to shareholders as seen from its ROE. It is no wonder that the company’s stock has rapidly appreciated with year -to-date gains of 88% (as of December 27th closing price). The importance of ROIC to a value investor cannot be undermined though it cannot be the only criteria to make an investment decision. We evaluate stocks across 50 different criteria. Click here to view our top stock picks.

To see Priceline’s latest stock price movement, click here Priceline (NASDAQ:PCLN)

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Neither Amigobulls, nor any members of its staff hold positions in any of the stocks discussed in this post. The author may not be a certified/registered investment advisor, and the opinions expressed should not be treated as investment advice. Buying and selling of securities carries the risk of monetary losses. Readers/Viewers are advised to carry out their own due diligence and consult their investment advisors before making any investment decisions. Neither Amigobulls, nor the author have any business relationship with any of the companies covered in this post.

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