Return on capital, or return on invested capital, is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits. The ratio is calculated by dividing the after tax operating income by the average book-value of the invested capital.
Return on invested capital formula
There are three main components of this measurement that are worth noting:
While many financial computations use market value instead of book value, ROIC uses book values of the invested capital as the denominator. This procedure is done because, unlike market values which reflect future expectations in efficient markets, book values more closely reflect the amount of initial capital invested to generate a return.
The denominator represents the average value of the invested capital rather than the value of the end of the year. This is because the NOPAT represents a sum of money flows, while the value of the invested capital changes every day. Because the exact average is difficult to calculate, it is often estimated by taking the average between the IC at the beginning of the year and the IC at the end of the year.
Some practitioners make an additional adjustment to the formula to add depreciation, amortization, and depletion charges back to the numerator. Since these charges are considered "non-cash expenses" which are often included as part of operating expenses, the practice of adding these back is said to more closely reflect the cash return of a firm over a given period of time. However, others may argue that these non-cash charges should remain left out of the formula as they reflect the decline in the useful life of certain assets in the denominator.
Relationship with WACC
Because financial theory states that the value of an investment is determined by both the amount of and risk of its expected cash flows to an investor, it is worth noting ROIC and its relationship to the weighted average cost of capital. The cost of capital is the return expected from investors for bearing the risk that the projected cash flows of an investment deviate from expectations. It is said that for investments in which future cash flows are incrementally less certain, rational investors require incrementally higher rates of return as compensation for bearing higher degrees of risk. In corporate finance, WACC is a common measurement of the minimum expected weighted average return of all investors in a company given the riskiness of its future cash flows. Since return on invested capital is said to measure the ability of a firm to generate a return on its capital, and since WACC is said to measure the minimum expected return demanded by the firm's capital providers, the difference between ROIC and WACC is sometimes referred to as a firm's "excess return", or "economic profit".
