Return on Invested Capital or ROIC calculation points out the profitability of a company’s equity and debt. Equity plus debt equals total capital, the amount of available resources a company utilizes. ROIC is a better indicator of stock quality and strength than Return on Equity because it takes a company’s debt into account.
Example of How Return On Invest Capital Affects Investment Returns
Imagine these two scenarios with Company A and Company B.
To make things easy, let’s say Company A earned $10,000 (less dividends) last fiscal year and in the same year amounted $40,000 in equity and $20,000 in debt.
Company B earned $15,000 (less dividends) in that same year and amounted $75,000 in equity plus $2,000 in debt.
Comparison of ROIC from Two Firms
At first glance, most would consider Company A the better purchase. Company A posted a Return on Equity ratio of 25% ($10,000/$40,0000 = 25%).
Company B posted a Return on Equity ratio of only 20% ($15,000/$75,000 = 20%). Some investors would have concluded on Company A as the better investment and moved on, but we know about the true power of ROIC.
Now, let’s examine ROIC. Company A has a ratio of only 16% ($10,000/$40,000 + $20,000 = 16%) while Company B boasts a ratio of 19%. That’s a three percentage points increase in total return on investment coming from Company B. Remember when you own equity in a firm, you are also responsible for any incurred debt. Company B invests its total capital more efficiently than Company A does even though its ROE ratio is five percentage points lower.
From this example, we realize ROE cannot stand alone as the single evaluation tool. ROIC gives investors a much broader scope of a firm’s management, business model, and profitability.
