How to Calculate Return on Invested Capital

Summary

This video explains how to calculate a company's Return on Invested Capital (ROIC) by using different variations of the basic formula. It outlines key profit measures like EBIT, NOPAT, and net income, and compares various ways to calculate invested capital, including debt and equity, and adjustments like cash equivalents. The video includes examples from companies like McKenzie, Pepsi, and Target, showing how they calculate ROIC. It also emphasizes the importance of comparing ROIC with the Weighted Average Cost of Capital (WACC) to assess whether a company is creating or destroying value.

Takeaways

• 😀 ROIC (Return on Invested Capital) is calculated by dividing a company's profit by its invested capital.
• 😀 There are various ways to measure profit when calculating ROIC, such as using net income, EBIT, or NOAT (Net Operating After Taxes).
• 😀 Invested capital can be measured by averaging debt and stockholders' equity, or adjusting for cash and cash equivalents.
• 😀 McKenzie recommends using NOAT (Net Operating After Taxes) divided by invested capital for calculating ROIC.
• 😀 The Wall Street Journal uses a formula where profit is measured as EBIT multiplied by (1 - tax rate), and invested capital is debt and equity minus cash.
• 😀 Companies like Pepsi use net income plus after-tax interest expense to calculate ROIC, and Target has a more complex formula involving operating lease liabilities.
• 😀 A basic ROIC formula involves using NOAT in the numerator and the average debt and equity in the denominator.
• 😀 The formula can be illustrated with an example: If a company has $10 million EBIT and a 25% tax rate, its NOAT would be $7.5 million.
• 😀 To calculate ROIC, the average of debt and stockholders' equity is used in the denominator, and for a company with $10 million beginning debt and $220 million ending debt, the average would be $200 million.
• 😀 Comparing ROIC to the company's Weighted Average Cost of Capital (WACC) helps assess if the company is creating or destroying value: ROIC should be higher than WACC for value creation.

Q & A

What is Return on Invested Capital (ROIC)?

ROIC is a financial metric that measures the profitability of a company relative to its invested capital. It helps to assess how well a company is generating profits from its investments.

How is the basic formula for ROIC structured?

The basic formula for ROIC is: Profit (which can be Net Income, EBIT, NOPAT, or NOPlap) divided by Invested Capital.

What are some common measures of profit used to calculate ROIC?

Some common measures of profit include Net Income, EBIT (Earnings Before Interest and Taxes), NOPAT (Net Operating Profit After Taxes), and NOPlap (Net Operating Profit Less Adjusted Taxes).

How can NOPAT be calculated from EBIT?

NOPAT can be calculated by multiplying EBIT by (1 - tax rate).

What are the different ways to calculate Invested Capital?

Invested Capital can be calculated in several ways: the average of debt and stockholders' equity, the average of debt and equity minus cash and cash equivalents, or the average of debt and common stockholders' equity minus cash and equivalents.

What is McKenzie’s approach to calculating ROIC?

McKenzie calculates ROIC as NOPLAT divided by invested capital, where invested capital is the sum of the company's property, plant, equipment, and working capital.

How does the Wall Street Journal approach the calculation of ROIC?

The Wall Street Journal calculates ROIC by using NOPAT in the numerator and the sum of debt and equity minus cash and cash equivalents in the denominator.

What is Pepsi's method of calculating ROIC?

Pepsi calculates ROIC by using Net Income plus after-tax interest expense in the numerator, and the average debt and common stockholders' equity in the denominator.

How does Target calculate ROIC?

Target uses a more complex formula where the numerator is NOPAT and the denominator includes long-term debt, shareholders' equity, operating lease liabilities, minus cash and equivalents.

What does McKenzie recommend for calculating ROIC in practice?

McKenzie recommends using the basic formula: NOPAT in the numerator, and the average debt and stockholders' equity in the denominator, as a straightforward method for calculating ROIC.

How can ROIC be used to evaluate whether a company is creating or destroying value?

ROIC can be compared to the company's weighted average cost of capital (WACC). If ROIC is higher than WACC, the company is creating value; if ROIC is lower than WACC, the company is destroying value.