ROIC – How to Use It to Find Good Investments
What Is Return on Invested Capital (ROIC)?
Return on invested capital (ROIC) is a financial ratio that measures the profitability and efficiency of a company’s use of capital.
It is commonly used to assess whether a company is using its resources in an efficient manner, and it is considered to be a good indicator of a company’s overall financial health.
The formula for ROIC is:
ROIC = (Net Income - Dividends) / Invested Capital
where:
- Net Income is a company’s total after-tax profit
- Dividends are the cash payments paid out to shareholders
- Invested Capital is the sum of all the money that has been invested in the company, including equity and debt.
Net income minus dividends is also commonly known as net operating profit after-tax, or NOPAT.
Why Is ROIC Important?
ROIC is important because it measures a company’s profitability and efficiency in using capital.
A high ROIC means that the company is able to generate a lot of profit with relatively little capital, which is an indication of good management and a strong business model.
Conversely, a low ROIC indicates that the company is not using its capital efficiently, and this may be a sign that the business is not doing well.
ROIC is also considered to be a good predictor of future stock price performance. Studies have shown that companies with high ROICs tend to outperform the market over the long term.
ROIC: Return on Invested Capital
How to Use ROIC to Find Good Investments
There are a few different ways to use ROIC to find good investments.
ROIC relative to competitors
One way is to compare the ROIC of a company to its competitors. This will give you an idea of which company is more efficient in using capital, and it may be a good indicator of future stock price performance.
ROIC vs. WACC
Another way to use ROIC is to compare it to the company’s cost of capital, or weighted average cost of capital (WACC).
This will tell you whether the company is generating enough return on investment to cover its costs.
If the ROIC is lower than the cost of capital, then the company is not generating enough return and may be a risky investment.
On the other hand, if the ROIC is higher than the cost of capital, then the company is generating a good return and may be a good investment.
ROIC relative to future returns
You can also use ROIC to predict future stock price performance, such as through linear regression.
Some traders also plot P/E vs. future returns to assess relative valuations.
So, if you are looking for good investments, you should look for companies with high ROICs.
But, of course, never use any single financial metric in isolation.
Limitations of ROIC
ROIC is a good metric to use in assessing a company’s financial health, but it is not perfect.
There are a few things to keep in mind when using ROIC.
Ignores a lot of information
First, ROIC only measures profitability and efficiency in using capital. It does not take into account other important factors such as revenue growth, margins, or cash flow.
Can be manipulated
Second, ROIC can be manipulated by management through accounting techniques such as aggressive depreciation or share repurchases.
Depends on the investment choices management makes
Finally, ROIC can be affected by the investment choices that a company makes. For example, a company may choose to invest in long-term projects that have low returns in the short term but high returns in the long term.
This would lower the company’s ROIC in the short term, but it may be a good decision if the projects are successful.
Despite its limitations, ROIC is still a useful metric to use in assessing a company’s financial health and predicting future stock price performance.
When used in conjunction with other financial metrics, it can give you a good idea of whether a company is a good investment.
ROIC Derivatives
RONIC
Return on new invested capital (RONIC) is a metric used to help find the expected rate of return for deploying new capital on projects and services within a company.
It’s a forward-looking version of ROIC and is used to estimate returns for future periods.
To calculate RONIC, you need two inputs:
1) the expected rate of return for each project or service, and
2) the amount of new capital being deployed on each project or service.
The first input can be difficult to estimate, but you can use historical data or industry averages as a starting point.
The second input is simply the amount of new capital being invested in each project or service.
ROCE
Return on capital employed (ROCE) is a metric used to assess the profitability of a company.
It measures the return that a company generates on the capital it has employed.
ROCE is calculated by dividing a company’s operating profit by its capital employed.
Operating profit is revenue minus operating expenses. Capital employed is the sum of a company’s equity and debt.
So, ROCE tells you how much profit a company makes for each dollar of capital it has employed.
ROACE
Return on average capital employed (ROACE) is a metric used to assess the profitability of a company. It measures the return that a company generates on the capital it has employed over a specific period averaged out.
ROACE is calculated by dividing a company’s operating profit by its average capital employed.
As mentioned above, operating profit is revenue minus operating expenses and capital employed is the sum of a company’s equity and debt.
Average capital employed is the average of a company’s capital employed over a period of time.
Accordingly, ROACE tells you how much profit a company generates based on each dollar of capital it has employed averaged out over a period.
ROGIC
Return on gross invested capital (ROGIC) is a metric used to assess the profitability of a company. It measures the return that a company generates on the capital it has invested.
ROGIC is calculated by dividing a company’s operating profit by its gross invested capital.
Operating profit is revenue minus operating expenses. Gross invested capital is the sum of a company’s equity, debt, and investments.
So, ROGIC tells you how much profit a company makes for each dollar of capital it has invested.
ROIC vs ROE vs ROA vs ROI
FAQs – Return on Invested Capital (ROIC)
What Does Return on Invested Capital Tell You?
Return on invested capital (ROIC) is a profitability ratio that measures how much profit a company generates with the money that shareholders have invested.
ROIC is important because it measures a company’s profitability and efficiency in using capital. A high ROIC means that the company is able to generate a lot of profit with relatively little capital, which is an indication of good management and a strong business model.
Conversely, a low ROIC indicates that the company is not using its capital efficiently, and this may be a sign that the business is not doing well.
How do you use ROIC?
There are a few different ways to use ROIC.
One way is to compare the ROIC of a company to its competitors. This will give you an idea of which company is more efficient in using capital, and it may be a good indicator of future stock price performance.
Another way to use ROIC is to compare it to the company’s cost of capital. This will tell you whether the company is generating enough return on investment to cover its costs.
If the ROIC is lower than the cost of capital, then the company is not generating enough return and may be a risky investment.
On the other hand, if the ROIC is higher than the cost of capital, then the company is generating a good return and may be a good investment.
What are some drawbacks to using ROIC?
ROIC is a good metric to use in assessing a company’s financial health, but it is not perfect.
There are a few things to keep in mind when using ROIC.
First, ROIC only measures profitability and efficiency in using capital. It does not take into account other important aspects of a company’s operations, such as sales or customer satisfaction.
Second, ROIC can be affected by a number of accounting choices and estimates. For example, companies may use different depreciation methods, which can impact ROIC.
Third, ROIC does not always reflect true economic profitability. For instance, a company may have high ROIC but low cash flow because it is using aggressive accounting methods or has large amounts of debt.
Fourth, ROIC can be misleading when comparing companies in different industries. For example, a utility company will usually have a lower ROIC than a tech or digitally-based company because the capital requirements are different.
Overall, ROIC is a useful metric to consider when assessing a company, but it should not be used in isolation.
When used in conjunction with other financial metrics, it can give you a good idea of a company’s financial health and whether it is a good investment.
Key Takeaways – Return on Invested Capital (ROIC)
- ROIC is a financial ratio that measures the profitability and efficiency of a company’s use of capital.
- It is commonly used to assess whether a company is using its resources in an efficient manner, and it is considered to be a good indicator of a company’s overall financial health.
- ROIC can also be used to predict future stock price performance. Studies have shown that companies with high ROICs tend to outperform the market over the long term.
- ROIC only measures profitability and efficiency in using capital. It does not take into account other important aspects of a company’s operations, such as sales or customer satisfaction.
- Despite its limitations, ROIC is still a useful metric to use in assessing a company’s financial health and predicting future stock price performance.
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