This article was written by Willie Keng and was first published in Value Invest Asia on 17 July 2014.
In a previous article, Stanley explained the Return on Equity (ROE). While the ROE focuses on the equity component of a company’s capital investments, the Return on Invested Capital (ROIC) measures return earned on investments funded by equity and debt.
It shows how much profit a company generates for every dollar of investments it makes in the business. ROIC is expressed as a percentage and shown in the formula below:
We can calculate the ROIC using an example from Banyan Tree Holdings’ (SGX: B58) financial statement:
|Annual Report (SGD ’000)||Fiscal Year 2012|
|Property, Plant and Equipment||729,558|
|Fiscal Year 2013|
|After-Tax Operating Income||29,951|
|Return on Invested Capital (ROIC)||4.1%|
*The high tax rate was due to the different geographic segments the company operates in
Based on the calculations above, we note that Banyan Tree generated an ROIC of 4.1% for FY2013. Do note that either an average of the past 2 years or the prior year’s book value of invested capital should be used.
Analyzing a firm’s ROIC is complementary to the ROE because it gives investors an idea whether a company has efficiently utilized both equity and debt financing. A company that generates excess returns over its cost of capital is earning is expected to trade at a premium over a firm which does not earn similar excess returns. An investor can measure how the company has fared over the past 5 to 10 years in its capital utilization and can also compare the ROIC between peer companies to have a better understanding of how each company utilized their capital investments.
Value in Action
ROIC is a good complement to the ROE. The ROIC measures an after-tax operating income of a company given its capital investments in its fixed assets and non-cash working capital (current assets – current liabilities – cash). A company which earns a return above its cost of capital is expected to trade at a premium over a firm which does not earn that same excess returns.