Before sinking their hard-earned money into any company, savvy investors want to ensure their funds will generate returns. For every dollar spent, investors expect an additional level of earnings in the future. However, producing these sureties can be challenging. That’s why many investors use different metrics to analyze business performance, including operating margins, net operating income and payout ratios. But if they’re forced to only look at one metric to judge the quality of a company or real estate property, it should be the return on invested capital (ROIC). What exactly is ROIC, and how can it be calculated accurately? This article will tell you everything you need to know.
Return on invested capital (ROIC) is an essential metric investors can use to uncover how a business is using invested funds to generate more returns and expand the business. Simply put, ROIC examines how efficiently a business is using invested capital to provide shareholders with a better return on investments (ROI) and grow the company. Investors can also compare a business’s ROIC on investor funds with its weighted average cost of capital (WACC) to learn whether the capital is being effectively used. For example, a business that earns $2 can use that money to purchase new inventory and then sell those products to earn $2.50 the following year. As a result, the company has earned a return on invested capital of 25%. Bravo!
When it comes to properly calculating a company’s ROIC, investors want to see how much money the business is generating as it grows. A good way to calculate return on invested capital is to use a methodology that gives you a deeper understanding of a business’s potential to continuously create cash flow. To calculate the return on invested capital, use the following formula:
NOPAT/Invested Capital = ROIC
NOPAT is the net operating profit after tax, or earnings before tax (EBIT), that a company generates that is reduced by a “normalized” tax rate. Invested capital is the accruing amount of funds invested into a company’s core operations. It’s important to note that this ROIC formula excludes liabilities and non-cash assets from invested capital, including intangible and goodwill assets.
ROIC will differ from business to business. When it comes to commercial real estate, return on invested capital can measure the profit you can make on a real estate investment. A good return on invested capital in commercial real estate will vary by risk tolerance. The more you’re willing to risk, the higher return on investment you might get back. Investors who’d like to avoid potential risks may be happy to settle for lower ROICs in exchange for a sure bet. Understanding the ROIC of a commercial property can give you a better understanding if it’s worth your money.
One drawback of using return on invested capital as a metric is that it doesn’t reveal anything about what segment of a property is generating value. If an investor is making calculations based on net income — or sales minus taxes, depreciation and other expenses — instead of NOPAT, the results can be unclear. This problem is because returns could be coming from a single, non-recurring source.
To better understand return on invested capital, let’s look at an example. Let’s say that business X has a NOPAT/EBIT of $15,000, and the tax rate is 30%. The total equity is $40,000, the cash on hand is $6,000, and the total debt is $25,000. The NOPAT would be calculated using the formula:
NOPAT = EBIT (1-t)
For the example above, the formula would be:
NOPAT = $15,000 (1-30%)
NOPAT = $10,500
The invested capital formula is:
Invested Capital = Debt + Equity – Cash & Cash Equivalents
For business X, the invested capital formula would be:
Invested Capital = $40,000 + $25,000 – $6,000
Invested Capital = $59,000
The ROIC formula would be:
$10,500/$59,000 = 0.1779
Thus, the ROIC is $0.18.
Now that you know what ROIC is and how to calculate it, let’s explore some commonly asked questions about return on invested capital.
While the ROI focuses on a single activity, the return on invested capital looks at all of the activities a business uses to generate profits.
The ROIC calculation formula is NOPAT/Invested Capital = ROIC, or net operating profit after tax divided by the business’s invested capital.
If the final ROIC figure, expressed as a percentage, is more than a business’s WACC, that business is generating value for its investors.
Commercial real estate investors should always use return on invested capital (ROIC) to understand if a property is worth their while. Before you invest in commercial real estate, be sure to calculate the property’s ROIC to glean a better understanding if it will make you money.
