ROIC-New-Hot-Topic
Return on Invested Capital (ROIC) is a
financial profitability ratio that measures how efficiently a
company generates cash flow from the capital that is invested in
it. The formula divides an estimated measure of cash flow –
typically Net Operating Profit After Tax (NOPAT) – by a company’s
equity and debt minus its cash; a measure of how much capital
stock has been invested. The ROIC metric has become an important
calculation for a variety of users, including accounting and tax
professionals as well as investors.
Accounting and tax professionals need to understand the increasing
popularity of the ROIC metric. For example, accountants will find
the calculation useful since their clients will want to assess how
their respective ROIC ratios compare to those of industry peers.
Tax professionals should appreciate the mathematics behind the
ROIC calculation since it is a financial measure that reflects tax
planning results.
From the perspective of an investor, the higher the ROIC – the
better a company is at increasing its operating profits for every
dollar that is invested in it. If investors do not earn the
realized return they had expected, they will seek to sell the
asset.
Analyzing ROIC
ROIC is a popular financial metric
utilized for evaluating companies in various industries.
The following companies, taken from a sampling on TheStreet.com,
are above median relative to industry peers when observing ROIC
rates:
Weighted Average Cost of Capital (WACC) calculates
the presumed rate to be paid to all security holders for financing
assets. For example, if ROIC is greater than WACC, the difference
in percentage indicates that the company is generating more in
profits than it costs to continue business operations.
United Continental Holdings (UAL)is a leading
airline company in the U.S. Their ROIC rate of 56.25% shows that,
based on the cost of capital, UAL is very efficient at earning
operating income from invested dollars.
Furthermore, Brinker International (EAT), which owns
Chili’s and Manggiano’s Little Italy restaurant chains, has a ROIC
of 29.50%, which is high for the restaurant industry.
Finally, HCA Holdings (HCA), a leading hospital chain
operator, has a ROIC of 19.04%. While this percentage is certainly
lower than those of both UAL and EAT, this ROIC rate is still very
high for the industry.
In analyzing the above examples, it is clear that different
industries call for differing levels of financing. For example, an
airline company having a higher WACC than a restaurant chain shows
that investors require a higher rate of return on invested capital
for the airline industry than they do for the restaurant industry.
This is due to the fact that airline companies invest capital much
more intensively than companies in other industries that use fewer
capital assets. If a company’s cost of capital is higher, the
return will be higher from every invested dollar that is expected,
leading to a higher expectation for wealth creation.
When a company has a high ROIC rate, this does not necessarily
mean that it is better managed than one with a lower rate.
However, a company that shows a steadily increasing rate of ROIC
over time indicates a positive trend for business performance.
Conclusion
ROIC is becoming an important metric
when looking at a company’s ability to turnover an invested dollar
directly from core business operations. Business advisors that
recognize the merits of this will be able to better serve their
clients. Similarly, investors that pay attention to ROIC will have
a better understanding of a company’s profitability and wealth
creation ability. Even if a particular company currently has a low
ROIC, a positively up-trending ROIC is a favorable sign. As more
companies use the ROIC metric, the advisory community needs to
understand the essence of the calculation.
