ROIC Return On Invested Capital

[@TheFinanceStoryteller]

Enjoyed the video? Then subscribe to the channel, and watch my video on financial ratio analysis next: kzbin.info/www/bejne/g4XUaHurq9R6mc0

[@ProfitableAgribusinessIdeas]

Hi Finance, can you help? What if I bought a building and machine for a business worth for example usd2000 (as capital) and after one month I was able to get a sales revenue operation by usd5000? How is the proper way of calculating ROI, shall I include the capital in ROI? an example is Poultry Operation. Initial capital is USD 2000 and sales is USD. 5000. Thank you.

[@TheFinanceStoryteller]

Hello there! Yes, the returns go into the numerator, and you divide by the investment which goes into the denominator. For the returns, take the net profitability (revenue minus expenses including taxes). Maybe my video on ROI vs payback period can help: kzbin.info/www/bejne/pWXSl2Srg7iFn9U

[@ProfitableAgribusinessIdeas]

@@TheFinanceStoryteller Nice,, i watched and subscribed to your channel...very helpful

[@KrishanSingh-gz9op]

Is there any relation or Comparison between ROIC & WACC?

[@TheFinanceStoryteller]

Hi Krishan! Yes, it's called Economic Value Added: kzbin.info/www/bejne/gnm7gHx-hsishdk

[@loremipsum3625]

Thanks for your knowledge! Assuming a company bears no debt whatsoever, would it make sense to substitute the usage of ROIC metric for the ROE instead?

[@TheFinanceStoryteller]

Yes, that makes sense to me.

[@Alfoncos]

The Company defines ROIC as ..(net income including non-controlling interest plus after-tax interest expense)... I don't get after-tax interest expense. I thought interest expense is always before tax expense. Tax expense is not always last expense?

[@TheFinanceStoryteller]

From the net income perspective, you are right: interest expenses are deducted from operating income in order to get to earnings before tax (EBT). Income tax expenses is then calculated on this EBT. For ROIC, we take the returns generated for debt & equity holders in the numerator, and the capital supplied through debt and equity in the denominator. The after-tax interest expense is the return generated for the debt holders. So this has nothing to do directly with net income, it is the after-tax reward for bondholders. Does that make sense? If not, maybe the follow-up video ROIC vs ROE vs ROA vs ROI can clarify: kzbin.info/www/bejne/mXPEd3uIm9WCgZo

[@Alfoncos]

@@TheFinanceStoryteller Are there two types of lenders or debts? Those who are paid from EBIT and others who are paid from after-tax income? Interest expense from the net income perspective is not payed to bondholders? I have seen your ROIC vs ... videos, but that had not helped me to understand this issue.

[@TheFinanceStoryteller]

Nope. You are going in the wrong direction. ROIC is simply an expanded version of ROE. ROE looks at only one "supplier" of capital: shareholders. What is the return for the shareholder, versus the capital supplied by the shareholder. This is calculated as: net income divided by book value of equity. ROIC looks at two "suppliers" of capital: shareholders and lenders. What is the return for shareholders plus lenders, versus the capital supplied by shareholders plus lenders. This is calculated as: net income plus after-tax interest, divided by equity plus debt.

[@KrishanSingh-gz9op]

Can I calculate NOPAT using the following formula :- NOPAT = Operatign profit - tax expense

[@marduktr]

7:42 Sir,I didn't understand the Income tax adjustment. Is it operational tax after one off loses were excluded?

[@TheFinanceStoryteller]

From the annual report of Home Depot: "Income tax adjustment is defined as operating income multiplied by our effective tax rate". What the finance team at Home Depot is doing here is to calculate NOPAT, Net Operating Profit After Tax. This NOPAT metric is not something you can directly take from the income statement. Their effective tax rate is 37.0% in fiscal 2017, slightly higher than the 36.3% in 2016 and the 36.4% in 2015.

[@Michael.design]

In other words, companies present their ROIC's in such a way that it is better than it is actually. Better to use a financial data source that uses GAAP financials. Right?

[@TheFinanceStoryteller]

Hello Michael! I prefer to have both available: GAAP based calculations (without adjustments) and non-GAAP calculations like ROIC (the latter giving an insight as to what the company considers "unusual" or "non-operating"). The longer the list, and the higher the $ amount, of the adjustments, the more suspicious I get. When I take the GAAP based calculations to compare two companies (like ROE-ROA-ROS in DuPont analysis kzbin.info/www/bejne/mJnFdXeJpM19bpY ), then I will still want to know what could be explaining the difference in their performance. In other words, I always refrain from declaring an immediate "winner" based just on the outcome of ratio calculations.

[@Michael.design]

@@TheFinanceStoryteller Got it. Thanks for the elaboration! What other metrics would you consider crucial? In a way that a company needs to have that in order to be considered a good investment.

[@TheFinanceStoryteller]

Track record as well as future potential for organic revenue growth, margin improvement, and free cash flow generation: kzbin.info/www/bejne/oHiQoIuuapmkrqc

[@aldolabuonora]

debt (liabilities) plus equity equals assets? so why dont use assets in the denominator? thanks

[@TheFinanceStoryteller]

There's debt and equity in the broad sense, and in the narrow sense. As the examples of the various companies in the video show, ROIC often uses debt and equity in the narrow sense, making the number in the denominator smaller. Debt in the narrow sense is purely interest-bearing borrowings, excluding accounts payable, pension liabilities, etc.

[@aldolabuonora]

So is equity plus long term debt?

[@TheFinanceStoryteller]

There isn't just one "uniform" definition of ROIC, as the video is showing with the examples of how various companies define it. At timestamp kzbin.info/www/bejne/rX3ZdKB8eap1jsU you can see how 3M defines it: short term borrowings, current portion of long term debt, long term debt, and total equity.

[@PankajSingh-br8xw]

Please upgrade your mic.....

[@TheFinanceStoryteller]

Done! Please check one of my more recent videos, and you will hear the difference!!!

[@richardsalley9848]

Since there is no GAAP standard for determining this ROIC value, I can only assume that companies will come up with there own methods to calculate this, and there method will be whatever method that makes this value higher? Hence, there should be a GAAP standard for this calculation..."To keep companies honest"? Would that be a fair statement?

[@TheFinanceStoryteller]

Agree. Whenever you see an ROIC number, check the calculation behind it instead of taking the number at face value. A GAAP standard on ROIC and other ratios would be very nice, but I don't think the FASB would want to go that far.... By the way, to understand GAAP vs non-GAAP I have made a specific video as well (not sure if you have seen that one yet): kzbin.info/www/bejne/m6jdnZqkfNmZo8k

[@richardsalley9848]

@@TheFinanceStoryteller I'll take a look. Thanks!

[@Concojone5]

Thank you for helping us laymen understand these concepts!

[@TheFinanceStoryteller]

You're welcome!!! Thank you for watching and commenting.

[@isaackarechu156]

I can tell you have read The Little book of value investing/valuation. Fantastic video!!

[@TheFinanceStoryteller]

Thank you for the kind words, Isaac! No, I haven't read that book, but probably some others with a similar message.

[@StockTalkwithNikoKritikos]

Do you think ROIC is a better metric than ROE or ROA?

[@TheFinanceStoryteller]

I think ROIC is slightly more informative. Sadly, as every company seems to define ROIC in their own unique way (see examples in the video), it doesn't really help to compare performance between companies. On top of that, all of these (ROIC, ROE, ROA) are based on historical accounting data, so look back at what already happened. Historical results are no guarantee for future performance....

[@vinbat1990]

Brilliant explanation.Just a question.Is there any difference between ROIC and ROCE?If yes can you plz explain with an example?

[@TheFinanceStoryteller]

Thanks for the compliment, Vinayak! I have not researched ROIC vs ROCE in detail, but as far as I know the main difference is for American companies to talk about ROIC and European companies to talk about ROCE.

[@sebbastian8524]

Hi Sir, I would like to ask what is the difference between Invested Capital and Capital Employed? And do you have a video explaining the difference of ROIC and ROCE? Thanks!

[@TheFinanceStoryteller]

Hello Ian! I am not totally sure, ROIC and ROCE seem to be very close variations on the same theme, would need to do more research to give you a specific answer. In a quick search, I found the following description: "Capital Employed has many definitions. In general it is the capital investment necessary for a business to function. It is commonly represented as total assets less current liabilities (or fixed assets plus working capital requirement)." So in my view, ROIC approaches things from the right-hand side of the balance sheet (invested capital: debt plus equity), whereas ROCE seems to approach things from the left-hand side of the balance sheet (the way the capital is put to use).

[@knobi3760]

Hi, well explained :) One Question: Since I know about the importance of drivers of value (which are rev. growth and ROIC according to McKinsey's book on valuation), I put ROIC in my stock screener to watch out for companies with a high ROIC first. Then I look to rev. growth. What I am still wondering about, is, if there is any way to compare the combination of rev. growth and ROIC among companies. Example: Company 1 has ROIC of 30% (5y. avg.) and rev. growth of 5% (5y. avg.), Company 2 has ROIC of 20% (5y. avg.) and rev. growth of 15% (5y. avg.). Which one offers best bang for the buck? Is there any way to calculate future earnings (EPS) based on these two metrics like you can do that with the DCF Method where you get one result and can easily compare it among companies?

[@TheFinanceStoryteller]

The limitation of ROIC is that it is based on historical accounting data, in other words you are looking in the rearview mirror to see what happened in the past. Neither ROIC, nor expected revenue growth, nor EPS, take hidden risk into account. What I use in reviewing and selecting stocks is my assessment of convex positive payoff opportunities (which makes a stock attractive), as well as "blowup" risk (which makes it unattractive). I would suggest to read the works of Nassim Taleb (particularly "The Black Swan" and "Antifragile"), and study what happened at General Electric (failed Alstom deal and other trouble) and Boeing (737 MAX). Their metrics (ROIC, EPS, etc.) looked fine for a very long time, until they "blew up" due to hidden risk.

[@ahilesh228]

Thank you

[@TheFinanceStoryteller]

You're welcome

[@suexu2245]

Well explained, thanks!

[@TheFinanceStoryteller]

You're welcome, Sue! :-)

[@jd5787]

How useful is ROIC? I would have expected ratios derived from CFO or FCF (like ebitda/FCF conversion ratio) to be preferred over ratios derived from net income.

[@TheFinanceStoryteller]

Bonjour, Flying Frenchman! I agree with you that cash flow based metrics might be more meaningful, but the common practice in business and investing still seems to be to use income (P&L) based ratios like ROE (Return On Equity) and ROIC. For companies that are not very capital intensive, and do not have much or any physical goods they trade, there is not much of a difference. For industrial companies, with lots of fixed assets and significant working capital, the difference can be material.

[@jd5787]

@@TheFinanceStoryteller Thanks for your reply. Makes sense... I did a bit of reading on ROIC since I posted. Looks like quite a bit of adjustments are needed to calculate the numerator properly. Not super straightforward but an important indicator to look at

[@TheFinanceStoryteller]

Agree! ROIC is not easily comparable across companies, it's always advisable to review/replicate the calculation if a company provides an ROIC number to you.... As evidenced in the examples in the video.

[@TonyFernandes17]

In the denominator I see many articles quoting that we have to use invested capital/net operating assets. Is this right?

[@TheFinanceStoryteller]

Hi Tony! Return on Invested Capital (ROIC) is not defined under U.S. generally accepted accounting principles, so there is no "have to". As the video shows, different companies have slightly different ways to calculate. To me, defining invested capital as debt plus equity makes sense, in other words approaching it from the right-hand side of the balance sheet. Given the accounting equation assets = liabilities + equity, I guess you could also approach it from the left-hand side of the balance sheet and get to a similar number in the denominator. If you choose to divide by net operating assets, then I would call the calculation RONOA (Return On Net Operating Assets).

[@duartepombo551]

@@TheFinanceStoryteller From the book that I am studying (Business analysis and valuation PHP IFRS standards edition), They define ROIC as (NOPAT + NIPAT)/invested capital, why are we not including NIPAT (net investment profit after tax) here?, did we include it in the GM analysis?? and about your reply to +Tony Ferns, this book also differentiates RNOA from ROIC, being ROIC = (Return on net operating assets x (Net operating assets/invested capital) + (Return on non-operating investments x (non-operating investments/invested capital), being RNOA = NOPAT/net operating assets and RNOI = NIPAT/non-operating investments.

[@TheFinanceStoryteller]

@@duartepombo551 Sounds like the author of that book further complicates things and comes up with his own terminology. Never heard of NIPAT before.

[@duartepombo551]

@@TheFinanceStoryteller great book I recommend 👍although I am taking too much time to study for the exam because it is so detailed

[@TheFinanceStoryteller]

@@duartepombo551 Yeah, sounds like quite a challenge at 672 pages! Consider those exams a "rite of passage". The real fun starts in getting involved in real world acquisition projects. Fast-paced and heuristics-based. :-)

[@mortysmith7627]

Doesn't NOPAT in the numerator under represent what is actually available to all the capital owners? Because EBIT * (1-Tax) does not include the effect of interest on tax. Let me illustrate with an example. EBIT = 100; Tax = 40%; NOPAT = 60; Interest expense = 10. NPAT = 54. Now, total income for the shareholders = 54. Total income for the debt holders is 10. Essentially, the total return for all capital providers is 54+10=64, which is greater than the NOPAT=60..?

[@TheFinanceStoryteller]

NOPAT is a crucial measure in a variety of financial analyses because it gives a clearer view of operating efficiency -- a view that is not clouded by how leveraged the company is or how big of a bank loan it was able to get.

[@mortysmith7627]

I agree with that. But you'e explaining why NOPAT is a useful measure. I'm saying, in this formula, shouldn't the numerator just be Net Profit + Interest rather than Net Profit + Tax adjusted Interest, because the actual 'return' for all capital owners is net profit (for equity shareholders) + Interest (for debt owners)

[@TheFinanceStoryteller]

Hello Morty! The whole idea of NOPAT is to exclude the effect of leverage, hence the emphasis on OP (Operating Profit). Whether you go from "top to bottom" in the income statement, or from "bottom to top" in the calculation, should not make a difference. Using the numbers in your example: 100 * (1 - 40%) = 60, just like 54 + 6 = 60. If we would use your proposal of using Net Profit + Interest, then the more interest I pay, the better NOPAT would become, and leverage would be making a difference.

[@leroylin592]

it is helpful thx

[@TheFinanceStoryteller]

Glad to hear that, Leroy! Thank you for watching and commenting.

[@marcodellomo7070]

Greatly explained!

[@TheFinanceStoryteller]

Grazie 1000!

[@maxjames00077]

Great video! One question, how do buybacks effect ROIC? If a company does a lot of buybacks, like Apple, it lowers equity. Apple has lowered their equity from 135 bn to 50 bn in 5-6 years. Wouldn't that artificially increase ROIC?

[@TheFinanceStoryteller]

ROIC is usually calculated as Net Operating Profit After Tax (NOPAT) divided by the sum of debt and equity, so I agree with your statement that buybacks lower equity and increase ROIC. Similar effect on EPS (Earnings Per Share): kzbin.info/www/bejne/ioO8kKCgnMyAh7s And here's the link to my balance sheet analysis of Apple in their latest financial year: kzbin.info/www/bejne/gJCUd2t9pLGCf5o

[@maxjames00077]

@@TheFinanceStoryteller thanks

[@Michael.design]

Could you explain why other current and non current liabilities are not added as well in the invested capital formula? I understood those are interest bearing liabilities as well such as leases meaning they have a cost. Or aren’t they? Would you also subtract cash and equivalents or not? If not, why not? Everyone else seems to be doing that..

[@TheFinanceStoryteller]

Hello Michael! In ROIC (which is not a GAAP metric, therefore not rigorously defined, and existing in many variations), most people will try to define the debt part in the denominator as "true borrowings" from a bank or financial institution which are interest bearing. Therefore, things like accounts payable, accrued payroll, accrued income taxes, pension liabilities, etc. are excluded. You could subtract cash and cash equivalents in order to get to "net debt", but I personally have not seen that done very frequently. Whether or not that makes an impact depends on how big ("how material") that amount is.

[@Michael.design]

@@TheFinanceStoryteller Thanks! I was also leaning to not subtract the cash and equivalents. My thinking was that debt holders and equity holders provide capital and expect a certain return. Whether the company keeps those funds in cash or uses them is not relevant from an investors standpoint as long as the return surpasses the WACC. Am I right? You could still also calculate a return on operated capital in the sense to see what the return is based on the actual assets used. In that calculation you could leave out the cash as they maybe are not really operational. Correct? I was diving into how to correctly calculate invested capital but the internet left me more confused than before. There are so many ways. My conclusion for the moment is that theres a return for the investors (lendors and investors) and a return made on the assets actual used for operations. The latter I have a hard time constructing.. Which is why I’m now longing for just simple formulas haha. I would also argue that the return for debtholders and investors is most important as that will be the return determining the stock performance. For them it doesn’t really matter if income is earned via true operations or any investments. Income is income. Would you agree? Would love to hear your view on all this. Thanks a lot! You’ve somewhat become my main helpline in these advanced metrics:)!

[@TheFinanceStoryteller]

Hello Michael! Happy to help. You certainly bring up some interesting points and questions. I have a viewpoint on many of these, but not an "ultimate answer" on all of them. ;-) Let me try to comment point by point, highlighting your statements with M and my responses with P (for Philip, nice to meet you). M: I was also leaning to not subtract the cash and equivalents. My thinking was that debt holders and equity holders provide capital and expect a certain return. P: If we "zoom out", I would say there are multiple reasons why companies hold cash: business continuity (being able to pay salaries and suppliers, do CapEx investments, pay dividends) as well as optionality (moving in quickly if an attractive M&A opportunity arises, without having to go through a round to raise funding). Agree with you, in the sense that if companies have large/excess balances of cash sitting around doing nothing, then investors will rightly ask whether that's the best use of their cash! M: Whether the company keeps those funds in cash or uses them is not relevant from an investors standpoint as long as the return surpasses the WACC. P: Conceptually, I agree. However, there are many cases in the real world (tech companies such as Apple) where tens or hundreds of billions of cash and marketable securities are held, that surely have a rate of return lower than the WACC. A possible reason for this behavior is that tech companies may enjoy the "deep pockets" effect of scaring off other companies. The Big Tech companies have the cash to move into new sectors (healthcare, connected cars, etc), or intensify R&D effort in sectors they already play in, and throw so much money at it that they might simply win because of spending power. M: You could still also calculate a return on operated capital in the sense to see what the return is based on the actual assets used. In that calculation you could leave out the cash as they maybe are not really operational. Correct? P: Disagree. As argued above, some of the reasons of having cash on the balance sheet date are very operational. To look at "operating assets", I would exclude goodwill and intangible assets. M: My conclusion for the moment is that there's a return for the investors (lenders and investors) and a return made on the assets actual used for operations. P: Agree! Right-hand side of the balance sheet versus left-hand side! M: I would also argue that the return for debtholders and investors is most important as that will be the return determining the stock performance. P: Partially correct, but remember that historical returns provide no guarantee for future returns. A big part of stock performance (willingness of investors to buy vs sell) is based on expectations of that company's future. M: For them it doesn’t really matter if income is earned via true operations or any investments. Income is income. Would you agree? P: As an investor, I am not excited if companies generate interest income "on my behalf", they might as well give the money back to me and have me decide myself if that's the way I want to generate returns (unless they get better deals than me). I do get excited if a company has very promising "equity-accounting" type minority investments (JVs, etc.) where they add value.

[@Michael.design]

@@TheFinanceStoryteller Nice to meet you too Philip! Many thanks again for the reply. Exactly the reply I was hoping for as you bring so much value to the table! I agree with all that you say. Makes a lot of sense. Will definitely take these answers into consideration when judging companies. One thing if I may ask. I find it difficult to determine which assets to include calculating the ROIC on the operational side. I'm using an API that retrieves a standardised balance sheet with the asset side made up like below. Which assets would you include in the calculation? This one is from Apple. As you can see there is no goodwill and intangibles but my guess is that it is included in the other non current assets maybe? Would you just use net working capital + the rest or use a more selective approach? Again much appreciated! Apple Cash and Cash Equivalents 27,502,000 Short Term Investments 20,729,000 Cash And Short Term Investments 48,231,000 Net Receivables 42,242,000 Inventory 5,433,000 Other Current Assets 16,386,000 Total Current Assets 112,292,000 Property Plant Equipment Net 40,335,000 Goodwill 0 Intangible Assets 0 Goodwill and Intangible Assets 0 Long Term Investments 131,077,000 Tax Assets 0 Other Non Current Assets 52,605,000 Total Non Current Assets 224,017,000 Other Assets 0 Total Assets 336,309,000

[@TheFinanceStoryteller]

Hello Michael! For ROIC, I would go to the other side of the balance sheet (liabilities and equity), as that is where the "IC" part is located. I agree with your guess that goodwill and intangibles are likely to be included in the other non current assets. Even if you go through the full Apple 10-K, you strangely enough do not find more detail on it. At 82 pages, the 10-K is surprisingly short and lacking detail for a company that size!!!

[@KrishanSingh-gz9op]

But by applying tax rate deductions i.e. (1-tax%) on EBIT (i.e. Operating profit) aren't we overestimating tax? Because interest is paid before the tax and is tax deductible? So by calculating tax before subtracting interest expenses , we will end up calculating higher tax.

[@TheFinanceStoryteller]

Hi Krishan! I think you are missing the point of what ROIC is trying to do. In the numerator of the ROIC calculation are the returns generated for debt & equity holders, in the denominator is Debt plus Equity. There are two ways to get to the numerator. 1) With after-tax interest + Net Income, you start at the bottom of the income statement, and work your way up. 2) With Net Operating Profit After Tax, calculated as Operating Income * (1 - Tax Rate), you start a little higher in the income statement, and work your way down.

[@KrishanSingh-gz9op]

@@TheFinanceStoryteller Still don't get it. I am not getting why we are overcalculating tax by applying tax rate on EBIT instead of EBT. I know that we are calculating returns for both the debt & equity holders. But I think calculating returns for them by applying tax rate on EBIT is a wrong approach. If we wanted to calculate the return for debt & equity holder , then the numerator should be = PAT + INTEREST - TOTAL TAX PAID (in amount)

[@TheFinanceStoryteller]

We are stuck in words. Let's look at numbers to clarify. EBIT 110, Interest 10, EBT 100, Taxes 20, Net income 80. NOPAT = Operating Income * (1 - Tax Rate) = 110 * (1-20%) = 110 * 0.8 = 88. Net income + after-tax interest = 80 + 10 * (1-20%) = 80 + 10 * 0.8 = 80 + 8= 88. Same number.

[@KrishanSingh-gz9op]

@@TheFinanceStoryteller But the tax which the company is going to pay = 100 *(1-20%) =80. Where as your calculated tax is 88 rupees. You are overestimating tax by 8.

[@TheFinanceStoryteller]

Actual tax expense in the P&L is indeed 20. We agree on that. The reason I calculate the 88 (in two ways, as shown above) is that 88 is the input (numerator) for the ROIC calculation. To compare apples to apples, we take net income (which is after tax) plus after-tax interest in the numerator, and divide by the sum of debt and equity in the denominator. That's the way 3M and Home Depot approach the ROIC calculation as well, as shown in the video.

[@TheBestOfAllTylers]

Great video, thank you

[@TheFinanceStoryteller]

Thank you, Tyler! Glad you liked it!

[@konstancyja82]

I'm confused of why do we need the ROIC and what's the difference between ROIC and ROI?

[@TheFinanceStoryteller]

Good questions! 1) ROIC is a great way to look at "bang for the buck", what returns are being generated on an annual basis on the invested capital. In ROIC (Return On Invested Capital), the returns are (usually) defined as after-tax interest + Net Income, and the invested capital as debt and equity. So if $ of debt or equity was invested into the company, how much annual return is being made on that. The higher the ROIC, the better, assuming it is sustainable and not a one-off. 2) I would use ROI in project situations. I buy a new machine for $100K, how much margin will I generate on that machine per year. I buy a piece of software, how much productivity do I generate for the employees. With ROI, the higher the better applies as well. So ROIC is used for big picture total company situation, ROI for specific projects/investments.

[@TheFinanceStoryteller]

I have made a short video in response to your question! Why do we need ROIC ROE ROA and ROI, and what are the similarities and differences between these financial metrics? kzbin.info/www/bejne/mXPEd3uIm9WCgZo

[@stantan6130]

Why don’t we use cash flows from operations instead of nopat? Other than nopat being after tax.

[@TheFinanceStoryteller]

@@stantan6130 There are many variations on the theme... For example Cash return on capital invested (CROCI) which takes EBITDA divided by Equity. Still not CFOA, but closer....