Return on Invested Capital is an important concept in understanding the value of a company, but one that most people starting out in finance (and a lot of experienced people) don't fully appreciate (or understand at all).
Let's take a look at two companies that appear to be performing quite differently at first glance:
Company A is generating a substantially higher return on equity than Company B, so at first glance it could be tempting to think that Company A is a better investment or should justify a higher share price. If we assumed that the Cost of Equity of each company is 10% and that neither company will grow any further (stagnant), then the equity of Company A is worth 44.1%/10% x 400m = $1764m and has an Enterprise Value (debt + equity) of $2364m, and Company B has an equity value of 24.9%/10% x 800m = $1992m and an Enterprise Value of $2192m. So apparently Company A is worth $172m more than Company B.
On examination we can also see a few things that are very similar about these two companies: The same asset levels, the same sales and EBIT (earnings before interest and tax). The things that differ about the two companies are related to the capital structure of the companies. Company A has higher debt and lower equity invested, which means that it pays a higher level of interest (which is tax deductible), leading to a lower level of tax paid. So through higher gearing it has achieved a higher Return on Equity.
ROIC (Return on Invested Capital) attempts to assess companies based on their operating performance, independent of their capital structure. ROIC is a measure that removes the effect of leverage, and allows you to compare companies based on the performance of their assets, independent of any additional financial risk the management have taken in running their companies.
The trick with ROIC is to ignore the effects of the capital structure on the financial statements. As such on the balance sheet instead of differentiating between Debt and Equity, we add them together to get Invested Capital. On the profit & loss statement we ignore the effects of debt, so below the EBIT line we ignore interest and recalculate tax as if no interest was charged. The resulting version of NPAT that we arrive at is referred to as Net Operating Profit After Tax (NOPAT). To get ROIC, we then divide NOPAT by Invested Capital. Let's re-examine the two companies we looked at before on this basis:
We can see from the above table that the ROIC of companies A and B are identical at 21%. What this tells us is that, assuming all else equal, the assets of each company are worth the same amount as they provide the same return to their capital providers. So, if the assets are worth the same amount under this analysis, but Company A was worth more when we ran through a quick valuation above, how do we reconcile the difference? The way to reconcile the difference is by recognising that the additional financial leverage that Company A is using has increased the riskiness of that company compared to compay B, and therefore a higher cost of equity should be used in measuring the value of the equity of company A than company B. In practice it is also likely that company A would be charged a higher interest rate than company B as well.
Note that this methodology is great for valuing assets, however in practice management can add value to equity providers by managing for lower interest costs (in % terms), so ROIC is not the only thing to consider when valuing a company, but it should be a tool in any good analyst's analytical methods.