How to Calculate Return on Invested Capital (ROIC)

A real world example using 3M's 2020 annual report

ROIC is a fundamental metric that gives an indication of how much value a company can create from its injected capital. A company with a high ROIC can be seen as being good at turning a profit, especially if the ROIC is larger than the average for their sector.

Below is the formula for calculating ROIC. Here we use the net operating income after tax (NOPAT) and invested income as our numerator and denominator.

The ROIC is expressed as a percentage and indicates the return a company makes on the capital used. The ROIC by itself is not useful unless it is compared against the cost of capital. For example, if we have a ROIC of 5%, but the cost of capital is 7% then the company is destroying wealth by 2%. We want to get a positive return on capital, a larger percentage can be seen as better.

A good comparison on ROIC is the weighted average cost of capital (WACC) which we cover in another article.

A real world example

Lets look at the company 3M (ticker MMM). We will get all required inputs from the 2020 annual report. We'll be using both the balance sheet and the income statement (found on page 56 and 57).

First we need to calculate Net operating profit after tax (NOPAT):

• Operating income is 6.822 billion.
• Tax rate as a percentage. We will need to divide the income tax expense by the earnings before taxes.
  • Income tax expense is 1.318 billion.
  • Earnings before tax (income before tax on income statement) is 6.711 billion.
  • Tax rate = (1318 / 6711) × 100 = 19.64%

NOTE: the above figures are found on the income statement of the 2020 annual report.

NOPAT = 6.711 × (1 - 0.1964), which comes to 5.392 billion.

Next we have to calculate invested capital. There are two approaches to calculating invested capital: the operating approach or financing approach. The operating approach factors in goodwill and intangibles. Because the goodwill and intangibles entry accuracy is debated (source) we'll use the financing approach.

• Total short-term debt is 1.062 billion.
• Total long-term debt is 17.989 billion.
• Total lease obligations, we'll use capital lease which is 0.256 billion.
• Total equity which is = (total assets - total liabilities).
  • Total assets is 47.344 billion.
  • Total liabilities is 34.413 billion.
  • Total equity = 47.344 - 34.413 = 12.931 billion
• Non-operating cash and investments, we'll use cash flows from investing activities, -0.58 billion, and cash flows from financing activities, -5.3 billion (these values are found in the cash flow statement).

NOTE: unless otherwise stated, the figures above are all found on the balance sheet in the 2020 annual report.

Now we are ready to calculate invested capital.

Invested capital = 1.062 + 17.989 + 0.256 + 12.931 + (-0.58 - 5.3), which comes to 26.358 billion

ROIC = 5.392 / 26.358, which comes to 0.2045... (or ROIC is 20.45%) for the year 2020.

Comparing ROIC to WACC

Let's show the ROIC in context by comparing it to WACC. We calculated the WACC for 3M on the 2020 annual report over here.

ROIC - WACC = 20.45% - 4.82% = 15.63%

3M can be said to have created 15.63% worth of capital from debt and equity - the cost of that debt and equity. This value should then be viewed in context of other similar companies to determine whether 3M performed well.

Summary

We end up with a calculation of 20.45% for ROIC, which is not too far from 3M's own calculation for 2020 of 18.2%. But why are the values different? The 3M report uses slightly different inputs, for example they use the average invested capital instead of the explicit short term debt, long term debt, lease obligations and total equity as we do.

The values we have used, and the result we have arrived at, could be wrong. The calculation we have used is a widely accepted formula and the values are all taken directly from 3M's 2020 annual report, but there could still be an error in the calculation.

The point of this article is not the final ROIC figure we have arrived at but the process of arriving at the figure. Calculating the ROIC and others like it from first principles helps us understand these metrics better and improves our ability to understand company reports.

Recommended next article

Calculate the weighted average cost of capital