ROIC and growth are the two central drivers of value.


The numerator comes from the income statement. The denominator comes from the balance sheet.

NOPAT is net operating profit after taxes. It is often modeled as EBIT (1 – tax rate). While depreciation is a real cost, the amortization of intangibles is often added to adjust EBIT. Thus,

NOPAT = EBITA (1 - tax rate)

There is a fair amount of subjectivity in defining the denominator IC (invested capital).

It can be obtained from the asset or operating side of the balance sheet (recommended), or the right or financing side. I found this position paper from Credit-Suisse very useful. The authors present practical tips on how to think about IC, instead of getting caught up in some particular formula.  An illustrative example (CSCO) is used to animate some of these ideas.

Screenshot from 2017-05-08 08-56-19Essentially, IC should include all the “capital” (inputs that generate revenue over long time frames).

To the first approximation,

IC = total assets - non-interest bearing current liabilities

It definitely should include current assets, net PPE, and other operating assets. One can make several commonsense adjustments:

  1. If a company carries excess cash or marketable securities (over that required to run the business), then that should be excluded from IC. A recommended rule of thumb is cash equal to 2% – 5% of sales (ranging from mature to growth companies) are required in the running of the business. Any excess should be excluded from IC.
  2. If M&A is part of the company’s modus operandus, then one should not exclude goodwill, as it represents a true cost of doing business.
  3. Capitalize leases and R&D, since they have characteristics of debt and long-term assets, respectively.

Here are some other resources on ROIC that I found useful.

This paper by Damodaran, “Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications”, is quite readable, and presents some useful insights.

John Huber has some of the most well-articulated thoughts on ROIC. He has written several articles (compounding and high ROIC, and legacy versus reinvestment ROIC), which can be found on his website here.

This Bears-Stearns presentation on the role of ROIC in valuation has been floating around in a lot of different places.


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