Return on invested capital (ROIC) is a key metric to assess how efficiently a company utilizes capital invested in its operations. By calculating ROIC, investors can analyze the profitability and value creation potential of companies or investment projects. In this article, we will walk through ROIC formula examples using net present value (NPV), internal rate of return (IRR), and explain the meaning behind different ROIC multiples.
ROIC calculation approaches with NPV formula example
The net present value (NPV) approach is a common way to calculate return on invested capital. It discounts future expected cash flows to the present value, subtracts the initial investment, and calculates the return as a percentage. For example, if a project requires $100,000 upfront investment, and is expected to generate $150,000 total cash flow over 5 years, with 10% discount rate, the NPV would be $115,000. ROIC is NPV of $115,000 divided by initial investment of $100,000, which is 115%. This means for every $1 invested, the project returns $1.15 in present value. The higher the ROIC multiple, the more valuable the investment.
Using IRR method to derive ROIC ratio
Internal rate of return (IRR) is an alternative way to calculate ROIC. IRR is the discount rate that makes NPV equal zero. In the previous example, if we increase discount rate to 18.45%, NPV becomes zero. Therefore, the IRR is 18.45%. This means the project yielded 18.45% return on the invested capital of $100,000. Although NPV and IRR derive similar ROIC ratios, NPV is better for comparing projects of different sizes, while IRR is easier to interpret as a percentage return metric.
ROIC implications for investment analysis
A higher ROIC multiple implies the company or project creates value by generating returns exceeding its cost of capital. For stock investments, a ROIC consistently above cost of capital signals a competitive advantage. The company is able to reinvest capital at high rates of return. ROIC also helps estimate intrinsic value. For example, a bank with 20% ROIC and 10% cost of capital likely deserves a higher valuation multiple than a utility company with 7% ROIC and 5% cost of capital. By comparing ROIC trends over time, investors can identify improving or deteriorating return on invested capital.
Using ROIC and capital turnover to break down return
Return on invested capital can be further broken down into two components: – Profit margin – Capital turnover ratio Profit margin measures profitability on sales, while capital turnover evaluates asset efficiency. Their product equals ROIC. For example, a company with 10% profit margin, and invested capital turnover of 2x, would have a ROIC of 20% (10% x 2). This decomposition helps pinpoint whether high returns are driven by profitability or asset velocity.
In summary, return on invested capital calculated by NPV or IRR method is a key metric to evaluate investment value creation. Comparing ROIC to cost of capital benchmarks the return generation versus capital requirements. Analyzing ROIC trends and decomposition provides insights on profit drivers and indicates improving or weakening competitive advantages.