If I had to choose a single metric to track the health of a business, that metric would be return on invested capital (ROIC). This metric helps answer what I believe is the single most important question in business: can the business earn a fair return on the financial capital that is placed in it?
Defining ROIC
Return on invested capital is the operating profits per dollar of invested capital. By focusing on ROIC, we recognize that business profit, in and of itself, means relatively little. To see this, consider two companies, both of which generate $1 million in operating profit. Both companies are financed solely with equity. The investors in both companies require a 15% return on their investment. The first company has $10 million in financial capital on the balance sheet. The second company has $3 million in financial capital on the balance sheet. The first company has a ROIC of 10%, while the second company has a ROIC of 33%. Using this metric, the first company has destroyed value for its shareholders, since its ROIC is less than the investors’ required return. The second company has created value for its shareholders, since its ROIC is greater than the investors’ required return. This example highlights how ROIC can help us compare companies, even when they have the same level of accounting profits.
Calculating ROIC
The formula for ROIC is:
After-tax operating profits / Average invested capital
Notice that in the numerator we use after-tax operating profits, also called NOPAT (for net operating profits after taxes) instead of net earnings. This is because net earnings include financing costs. We want to exclude financing costs so we can see the earnings available to all forms of capital invested in the business.
In the denominator, we use average total capital. We calculate average total capital by summing debt and shareholders’ equity capital at the beginning of the period and debt and shareholders’ equity at the end of the period. We then divide the result by two. This allows us to factor in any capital that has been placed into the company throughout the period.
By using total capital, we can compare companies with different capital structures – i.e., different levels of debt and equity. This is important, since many companies generate high returns on shareholders’ capital by using high levels of debt, which can greatly increase risk for the equity investors.
Shortcomings of ROIC
ROIC does have several shortcomings. For one, a low ROIC does not necessarily indicate a poor business. Investors are more than willing to accept a low near-term ROIC for the possibility of a high future ROIC.
Similarly, a high ROIC does not necessarily indicate that the company will generate high returns in the future. A high ROIC invites competition. Enhanced competition generally leads to lower future profits.
Conclusion
Any shortcomings aside, I stand by my claim at the beginning of this post – ROIC is the single best metric for managing the health of a business. But it is best used as starting point for further analysis into a company’s operations and competitive position.
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