In the world of finance, efficiency and profitability reign supreme. Investors are on a perpetual quest to unearth the metrics that can provide insights into a company’s financial prowess. One such powerful tool at their disposal is Return on Invested Capital (ROIC).
Cracking the ROIC Code
Return on Invested Capital, or ROIC, is the secret sauce behind evaluating a company’s efficiency in allocating capital to generate profits. It is the litmus test for discerning whether a company is minting money efficiently or burning through its resources.
The ROIC formula is as follows: ROIC = NOPAT / Invested Capital
- NOPAT stands for Net Operating Profit After Tax, A company’s NOPAT is the operating profit adjusted for taxes, stripping away any one-time windfalls or unexpected gains. Now, let’s get into the nitty-gritty of how to calculate Invested Capital.
- Invested Capital represents the total capital used for generating profits. Invested Capital can be calculated in several ways, and the approach taken depends on what specifically you want to measure. Here are a few methods:
- Book Value Approach: This method involves adding the book value of a company’s equity to the book value of its debt and then subtracting non-operating assets such as cash, marketable securities, and assets from discontinued operations. This is typically the simplest method.
- Working Capital Approach: This approach first calculates the working capital, which is the difference between current assets and current liabilities. From there, non-cash working capital is obtained by subtracting cash from the working capital value. Finally, non-cash working capital is added to the company’s fixed assets.
- Alternative Approach: In cases where there are long-term liabilities not classified as debt or if there are minority holdings in companies deemed as non-operating assets, you can add fixed assets and current assets and then subtract current liabilities and cash to arrive at the book value of invested capital.
ROIC is typically expressed as a percentage and can be calculated on an annualized or trailing 12-month basis. The benchmark to assess ROIC is the company’s Weighted Average Cost of Capital (WACC), which represents the average cost a company incurs for its debt and equity capital.
Understanding the significance of ROIC is pivotal. A higher ROIC indicates that a company is efficiently using capital to generate profits, demonstrating that the company is not just profitable but also an effective capital allocator. If ROIC exceeds WACC, the company is on the right track, creating value for its shareholders.
However, it’s not just about exceeding WACC; the magnitude matters too. A common benchmark for value creation is a return of two percentage points above the company’s cost of capital. A 50% ROIC means a company can turn a $1 investment into $1.50, reflecting strong profitability and capital efficiency.
Conversely, an ROIC lower than WACC implies a decline in value and questions the sustainability of the business model. Some companies may even run at a zero-return level, signifying that they neither create nor destroy value. While they may not be value destroyers, they lack the capital to invest in future growth.
ROIC is particularly invaluable for investors and serves as a lighthouse guiding them towards companies that are diligent in allocating capital efficiently, thereby delivering a solid competitive advantage.
Real-Life Application of ROIC
Let’s illustrate the concept with an example. Consider Company X, which generates Rs 10 lakh in NOPAT, while its invested capital is Rs 1 crore. To calculate ROIC: ROIC = Rs 10 lakh / Rs 1 crore = 0.10 or 10%
In this case, Company X’s ROIC is 10%. If the WACC is, say, 8%, the company is creating value (10% > 8%), implying it’s a wise investment.
The ROIC-WACC Nexus
According to the most recent PwC report, the real estate sector presently exhibits an average Weighted Average Cost of Capital (WACC) of 7.2%. Now, let’s examine the performance of various real estate firms and identify those that are able to outperform this specified hurdle rate.
|S.No.||Name||Mar Cap Rs crore||P/E||Ind PE||Debt / Eq||Prom. Hold. %||Debt Rs crore||Debt 3Yrs Rs crore||ROIC %|
|5||Kolte Patil Dev.||3708.25||28.72||29.12||0.54||74.45||561.48||746.94||11.14|
|20||D B Realty||6836.34||N/A||29.12||1.47||53.83||2897.78||2127.80||-28.36|
Comparing a company’s ROIC with its WACC is akin to pitting its efficiency against the cost of capital. If ROIC consistently surpasses WACC, it’s an indicator of astute capital allocation, making the company a lucrative prospect for investors. Conversely, if ROIC falls short of WACC, it raises questions about the company’s ability to generate returns in excess of the cost of capital.
Investors often use ROIC as a screening tool, and a minimum ROIC threshold is typically set, ranging from 10% to 15%. The threshold depends on various factors, including the industry and the specific investment strategy. A higher threshold is preferable when considering capital-intensive sectors, such as manufacturing.
Creating Value with ROIC
Companies aiming to bolster their ROIC and generate economic value over the long term have several strategies at their disposal:
- Invest in Profitable Projects: Focus on high-return, profitable projects that yield ROIC higher than the company’s cost of capital.t
- Enhance Capital Efficiency: Improve asset turnover and inventory management to make the most of capital investments.
- Implement Operating Improvements: Boost profit margins and curtail unnecessary expenses to increase the bottom line.
- Optimize Capital Structure: Explore opportunities to lower the cost of capital, such as issuing debt at favourable terms.
- Identify and Terminate Value-Destroying Projects: Scrutinize projects that fail to deliver positive net present value (NPV) and consider divestment.
Return on Invested Capital is not just a financial metric; it’s a window into a company’s efficiency and profitability. By comparing ROIC to WACC, investors can unearth opportunities and avoid value traps. ROIC is more than just a number; it’s a compass guiding investors towards companies that understand the art of capital allocation, which, in the world of finance, can make all the difference.