How to calculate ROIC (Return On Invested Capital)?
We will start off with explaining how ROA (Return On Assets) relates to ROIC, go through
the definition of ROIC, and analyze the ROIC calculations of 3 well-known companies.
You learn most by applying concepts to real-life situations, so please watch the entire video
to get the full picture!
ROIC (Return On Invested Capital) is very closely related to the easier to understand
metric ROA (Return On Assets), so it makes sense to quickly walk through the definition
of ROA first.
Return On Assets is simply Net Income divided by Total Assets.
To find the Net Income of a company, you take its income statement or profit and loss statement,
and go to the very bottom: the line called Net Income, also known as “the bottom line”.
This is the numerator in the equation.
Then for the denominator, you turn to the balance sheet, and take the number of Total
Assets at the bottom on the left.
As a balance sheet needs to balance between what a company owns (on the left) and what
a company owes (on the right), you could also take the sum of all liabilities and equity,
as this is the same number.
So Return On Assets is very easy to calculate.
If you want to improve the ROA of your company, you either work on initiatives to generate
more Net Income, and/or initiatives to lower the Assets base.
This is covered in a related video on Return On Assets that I will link to.
What is the definition of ROIC and how does it differ from ROA?
Let me walk you through the semi-official definition of ROIC.
The reason why I call this semi-official will become clear to you when we go through the
examples of real-life companies disclosing their ROIC calculation later in this video.
In the numerator of the ROIC calculation are the returns generated for debt & equity holders,
in the denominator is Debt plus Equity.
More specifically, the returns generated for debt & equity holders are usually defined
as after-tax interest + Net Income.
Another description for the same thing is Net Operating Profit After Tax (NOPAT).
With after-tax interest + Net Income, you start at the bottom of the income statement,
and work your way up.
With Net Operating Profit After Tax, you start a little higher in the income statement, and
work your way down.
From this definition of ROIC, you immediately see that the numerator of ROIC under normal
economic circumstances is likely to be higher than the numerator of ROA: After-tax interest
+ Net Income should be higher than Net Income by itself.
For the denominator of the equation, the sum of Debt and Equity is lower than Total Assets.
Let’s walk through that for one of the companies whose ROIC we will review in more detail in
this video: 3M.
Total Assets (the denominator in the ROA equation) for 3M is $38 billion on December 31, 2017.
The sum of all debt and equity, which is short term debt,
long term debt, and equity is $25.6 billion.
If you compare ROIC to ROA, then the numerator in the ROIC equation is higher,
and the denominator is lower.
So in total, the outcome of the ROIC calculation should always be higher than the outcome of
the ROA calculation.
Let’s test that for 3 companies: 3M, General Motors, and Home Depot.
I have calculated their 2017 ROA using Net Income and the average year end balances for
Total Assets, and taken the ROIC as defined by each of the companies
straight from their 10-K filings.
ROA for 3M is 14%, ROIC is 21%.
ROA for GM is -2%, ROIC is 28%.
ROA for Home Depot is 20%, ROIC is 34%.
Let’s compare the way these three companies have defined and calculated ROIC, as we are
not looking at apples-to-apples comparisons.
3M has nicely summarized why!
Return on Invested Capital (ROIC) is not defined under U.S. generally accepted accounting principles.
Therefore, ROIC should not be considered a substitute for other measures prepared in
accordance with U.S. GAAP and may not be comparable to similarly titled measures by other companies.
The Company defines ROIC as adjusted net income (net income including non-controlling interest
plus after-tax interest expense) divided by average invested capital (equity plus debt)….”
So 3M’s definition is very similar to the semi-official definition I showed earlier.
Let’s go through each company’s ROIC calculation in detail.
3M ROIC.
The numerator is at the top: Net Income plus after-tax interest expense.
The denominator is below that: average invested capital which is the sum of average equity
and average debt.
The company actually uses the average of Q1, Q2, Q3 and Q4 ending equity and debt balances.
The outcome of the calculation is 21% ROIC as per the 3M definition.
General Motors ROIC.
GM does not use ROIC, but a metric called ROIC-adjusted.
The numerator for ROIC-adjusted is EBIT-adjusted.
To calculate EBIT-adjusted, GM takes Net Income of minus $3.9 billion (in other words a loss
of $3.9 billion) as the starting point, and makes adjustments to get to EBIT-adjusted
of $12.8 billion.
GM does not normally make a loss, but 2017 was an unusual year: a big loss from discontinued
operations (the sale of the European business: Opel/Vauxhall), and a negative impact of the
change in the US tax law.
These are the first two numbers that are added back in this reconciliation.
Then adjustments are made to add back net interest expense, as well as one-off unusual
items like restructuring.
The end result of this is what GM calls EBIT-adjusted,
this is the numerator in GM’s ROIC-adjusted calculation.
Then for the denominator, GM starts with average equity and adjusts that to average net assets.
This gets them to 28% ROIC-adjusted as per the GM definition.
This is different from the ROIC calculations of other companies, as the numerator is on
a pre-tax and excluding unusual items basis, and the denominator is on a net assets basis.
Home Depot ROIC.
Home Depot uses NOPAT (Net Operating Profit After Tax) in the numerator.
In the denominator is average debt and equity.
Here’s where it is useful to always read the narrative
of how ROIC is defined by the company.
In the case of Home Depot, ROIC is defined as NOPAT, a non-GAAP financial measure, for
the most recent twelve-month period, divided by average debt and equity.
They go on to state that: We define average debt and equity as the average of beginning
and ending long-term debt (including installments) and equity
for the most recent twelve- month period.
So in the definition of Home Depot, if you compare it for example to the definition of
3M, short term debt (on average $1.1 billion for Home Depot) is excluded from the denominator,
making the resulting ROIC slightly higher.
Home Depot’s ROIC, as per their definition, is 34%.
To understand ROIC, it is useful to start off with ROA.
The semi-official definition of ROIC is Net Operating Profit After Tax in the numerator
divided by Debt plus Equity in the denominator.
Always check the exact definition that a specific company uses before comparing ROIC’s, as
it is a non-GAAP metric.
I hope this explanation and discussion of ROIC (Return On Invested Capital) was useful
for you.
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