Return on invested capital (ROIC) is one of the finest indications of a company's capacity to increase its value.

What exactly is ROIC?

Return on invested capital is a metric used to evaluate a company's effectiveness in allocating its resources to successful investments.

ROIC tells us, as investors, how effectively a business is utilizing its capital to generate profits. We can establish whether a company is creating or destroying value for the company by comparing its ROIC to its weighted average cost of capital (WACC).

Why is understanding ROIC so crucial for investors?

ROIC is the excess return earned by a corporation over its average debt and equity capital costs.

Earnings, NOPAT, and invested capital, WACC, are the components of return on invested capital.

NOPAT, or net operating income after tax effects, can be calculated by multiplying operating income by one minus the normalized tax rate.

On the opposite side of the equation, invested capital is a bit more complex because it includes:

• Net working capital
• Net PP&E
• Additional operating assets
• Excess cash

Whereas net working capital is the difference between current assets and non-debt current liabilities, surplus cash is the difference between cash on the balance sheet and required cash.

Let's see a table that compares two organizations to determine the impact of the various drivers and to clearly explain the formula.

This exercise is one of my favorites’ since it demonstrates the various value drivers for companies. The preceding table depicts the influence of property, plant, and equipment investments on the returns of both companies.

Both are big corporations with comparable dimensions. They both generate huge sales and profits.

However, one of the keys to understanding a company's outcomes is examining the various margins throughout the income chain, from gross to net margins.

These numbers do not tell the whole story because both companies have comparable profit margins. Greater margins alone do not indicate which company is superior.

Rather, the determining factor is the invested capital, the denominator.

You could be shocked if you used the above table to compare other corporations, such as Google and Amazon or Walmart and Amazon.

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