Return on Invested Capital (ROIC) Formula
Return on Invested Capital (ROIC) is a top level way to measure the historical & current performance of a corporation across all the capital it has invested in its business. This capital comes from shareholders (investors), creditors who supply loans, credit as well as shares owned by management. One of the best ways to measure how a company has performed in the past on its allocated capital resources is by the Return on Invested Capital ratio. Other similar formulas such as the Discounted Cash Flow (DCF) measures the performance of a company based on its present & future cash flows, but they are easy to manipulate. For instance, a company could easily decrease its outgoing cash flows by:
- Postponing marketing expenses
A solid Return on Invested Capital ratio indicates strong management, efficient business operations & use of capital resources as well as value creation opportunities for the organization. The ROIC formula should be used with care as it can mean negative things for the organization such as not exploring growth opportunities for the organization, ignoring long term net positive value investments, stingy cash preservation, excessive convervatism, etc. To create growth in the future, companies must earn an ROIC above their Cost of Capital (WACC). The accounting formula for this relationship is:
There are 2 formulas we could use to calculate ROIC.
Note that the first formula does not subtract Interest in the numerator because the denominator includes debt capital.
In the 2nd formula, capital invested refers to all debt financing such as long term loans, common stock, preferred stock, options & warrants.
It is imperative to note that ROIC is just an accounting formula and suffers these drawbacks:
i) Can be easily manipulated by management.
ii) Changes when accounting policies are modified e.g. fair value accounting of assets & capital.
iii) Can be affected by currency exchange rates due to cost of capital.
Let's calculate Return on Invested Capital for Check Point Software Technologies Ltd. - ticker CHKP as of December 31st, 2009.
By looking at the income statement here http://www.google.com/finance?q=NASDAQ:CHKP&fstype=ii, we see this data:
A 69.28% of Return on Invested Capital is pretty impressive for a technology company, unless technology industry analysts can prove me wrong??