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ROIC-Return on Invested Capital
Our newly refined formula for ROIC is:
ROIC = after tax earnings / (total assets – non-interest bearing current liabilities)
There are other ways to look at ROIC, though. Some modify the denominator further by deducting goodwill from total assets. That makes sense because goodwill is an intangible asset which the company’s management does not have use of as they do with tangible assets. Intangible assets are financial capital not operating capital. A company with goodwill will look less productive on an operating basis than a company without goodwill.
The Real ROIC
So we continue removing all the distortions created by GAAP accounting to find more accurately how much cash you get out of a business for every dollar you put in. Real ROIC.
While interest, the cost of debt, is reflected on the income statement, the more intangible (but no less real) cost of the equity capital is not reflected at all. How often is it ever considered that equity costs money, but it does. When a shareholder gets equity (or stock), they expect that the stock will increase in value. The expected percentage increase is the cost of equity capital because if investors don’t get the expected return, whey will sell to a new investor who will have his idea of expected return. The consensus expectation of all investors who own the stock is the cost of equity capital. Just because it is not deducted out of earnings like debt doesn’t make it any less real.
This is why ROIC is so powerful. ROIC looks at earnings power in the context of how much capital is tied up in a business and what sort of return that capital is generating. The whole idea of “earnings growing by such-and-such” takes on less importance as a stand-alone concept when you’re looking at how much capital is being poured into a business. It is real easy to grow your earnings by investing more money into the business. However, it is not quite as easy to grow earnings by investing capital if you intend to maintain your current level of return on invested capital.