Return in Invested Capital (ROIC)

• ROE is a important indicators of a firm’s profitability and potential growth
• There are some pitfalls of using ROE for measuremen - ROE can be increased with debt. 
• ROIC corrects ROE's problem - looks at all moneys (by shareholder and lender) invested into company and how much profit the management can generate.
• It is arguably the best way to determine if a company has a moat.
• Investor focused on earnings growth and not ROIC would miss the fact that the earning growth was generated by how much capital (include debt).
• It is very useful as comparisons among companies within sectors. Highest ROIC = making more profits from every dollar invested - often show the biggest share price gain (shown by Joel Greenblatt's Magic Formula)
• Formula
• ROIC = NOPAT / Invested Capital 
• NOPAT = Net Operating Profit After Tax = Operating Income * (1 – Tax Rate)
• !!! Operating Profit (aka EBIT) -  not include items such as investments in other firms, taxes, interest expenses and other nonrecurring items  
• Invested Capital = Total equity and equity equivalent + total debt – excess cash and investments
• Excess cash  -  cash of a company has that is not required to operate the business. (1) interest income is not part of Operating Income (2) if company with significant cash balance - the divided result might yield too low
• or, we take the total asset and minus out non interest bearing liabilities
  Invested Capital =  Total Asset - Non Interest bearing current liabilities - Excess Cash
• =Fixed Assets + Current Assets – Non-interest bearing Current Liabilities – Excess Cash
• = Fixed Assets + Non-cash Working Capital
•  Non Interest bearing current liabilities  -  account payable (it is capital invested in the business by a company’s suppliers or contractors, not the company itself), deffered revenue and deffered tax.
• Long term investment - it is not operating assets and should be excluded
• Some people deduct goodwill from total assets as it is financial capital, not operating capital. If we do so, the amortization of goodwill need to add back to operating income.
•  Use of ROIC
• If company ROIC > 15% for number of years - it most likely has a moat.
• But a positive spread between ROIC and WACC alone doesn't justify an economic moat. Investors also have to think about the qualitative attributes--high barriers to entry, huge market share, low-cost production, corporate culture, patents, or high customer switching costs--that create an economic moat around a company's profits. 
• Compare the efficiencies of companies using ROIC in the same industry to determine which is a better one to invest in. 
• ROIC can also be compared to the firm’s cost of capital to conclude whether the firm has collectively invested in good projects. - A company creates value only if its ROIC is higher than itsWACC.
• Cost of Capital
• When company raise capital from owners or lenders, the investor require a return on their investment.
• Stable and predictable company will have a low cost of capital, while a risky company with unpredictable cash flows will have a higher cost of capital.
• Weighted average cost of capital (WACC) - all capital sources - common stock, preferred stock if any, bonds and any other debt - are included the calculation.  
• WACC = E/V * Re + D/V * Rd * (1 -Tc)
• E = Market Value of Equity
• D = Market \ Book Value of Debt
• V = Total Value of Firm = E + D
• Re = Required return of equity holders
• Rd = Required return of debt holders
• Tc = Tax rate (cost of debt is tax deductible) 
• Cash-on-cash returns are what we're looking for in calculating ROIC. We're trying to look past distortions that come from accounting conventions. Accounting is a rules-based system that allows for a number of choices that can be made by financial managers and approved by auditing firms and distort a company's true economic earnings.

References:-

• Return On Invested Capital kcchongnz (private)
• Five Cheap Companies that Create Value, Harness the power of high returns on invested capital by Elizabeth Collins
• ROIC-Greenblatt-and-Fool-Articles