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Return on Total Capital ROTC Definition, Example

how to calculate return on capital

The 10% ROIC implies that the company generates $10 of net earnings per $100 invested in the company. Suppose a company generated $10 million in NOPAT in Year 1 and invested an average of $100 million from the end of Year 0 to the end of Year 1. For such an endeavor, you can use our amazing discounted cash flow calculator, which can help you determine if the company you are buying is currently underpriced or overvalued. Both ROCE and ROIC determine the efficiency at which the capital on hand is allocated by a company. The current ROCE of a company can also be viewed in relation to that of its historical periods to assess the consistency at which capital is efficiently deployed.

Operating Profit Margin: Understanding Corporate Earnings Power

  1. Again we will go back to the financial reports to find our numbers to calculate the return on capital for Intel.
  2. Since profits paid out in the form of taxes are not available to financiers, one can argue that EBIT should be tax-affected, resulting in NOPAT.
  3. One common way to use ROIC as an investment decision-making tool is to compare the investment’s ROIC to its weighted average cost of capital (WACC).
  4. NWC affects invested capital since if operating assets increase, invested capital increases as well – which in turn decreases the metric (i.e. more spending is needed to sustain or increase growth).

For instance, if two companies operate in the same industry but one has a significantly higher ROC, it may be perceived as a better investment opportunity. To find the data, we need to calculate the formula; for all of it we will find on the income statement and the balance sheet. The takeaway here is that the more revenue generated per dollar of invested capital and the higher the profit margins, the higher the return on invested capital (ROIC) will be — all else being equal. Next, we’ll calculate the invested capital, which represents the net operating assets used to generate cash flow.

Step 1: Calculate Net Income

A common benchmark for evidence of value creation is a return of two percentage points above the firm’s cost of capital. ROIC is always calculated as a percentage and is usually expressed as an annualized or trailing 12-month value. It should be compared to a company’s cost of capital to determine whether the company is creating value. But as usual, reliance on a single metric is not recommended, so ROCE should be supplemented with other metrics such as the return on invested capital (ROIC), which we’ll expand upon in the next section. If we input those figures into the return on capital employed (ROCE) formula, the ROCE of our example company comes out to 15.2%. Given a ROCE of 10%, the interpretation is that the company generates $1.00 of profits for each $10.00 in capital employed.

NOPAT Calculation Example

Return on capital, return on invested capital, and return on capital employed are all sides of the same coin, but each with a different twist on the formula. The calculation of NOPAT is relatively straightforward since EBIT (or “operating income”) is taxed as if there is no debt in the company’s capital structure (and, thus, no interest expense). The ROIC formula is net operating profit after tax (NOPAT) divided by invested capital. Companies with a steady or improving return on capital are unlikely to put significant amounts of new capital to work. One is to subtract cash and non-interest-bearing current liabilities (NIBCL)—including tax liabilities and accounts payable, as long as these are not subject to interest or fees—from total assets.

how to calculate return on capital

On that note, value investors in particular prioritize investing in the equity of companies led by a management team that can efficiently allocate capital toward projects that create long-term, sustainable value. A higher return on invested capital (ROIC) can be considered an indication that a company is required to spend less to generate more profit. NWC affects invested capital since if operating assets increase, invested capital increases as well – which in turn decreases the metric (i.e. more spending is needed to sustain or increase growth). The ROIC ratio quantifies the profits that the company can generate for each dollar of capital invested in the company in a percentage.

how to calculate return on capital

Unlike ROC, ROIC takes into account the cost of borrowed capital, providing a more detailed perspective on how efficiently a company is utilizing all its available capital, inclusive of debt. For instance, a manufacturing company requires much more capital to operate than a software company. Therefore, if a manufacturing company has a return on capital of 5%, it might be favorable compared to other companies in the same industry. But a software company with the same return may be underperforming relative to its industry peers. Any dividends that have been paid out to shareholders should be subtracted from net income.

Return on invested capital (ROIC) is one of the most important ratios to consider when you’re thinking about investing in a company. It’s a ratio that measures how much money a business is able to generate on the capital employed. It’s typically reported in the “Fundamentals” section of your favorite online stock screener. In essence, the return on capital affects a company’s profitability, its competitiveness within its industry, and is indicative of its overall operational efficiency. So, while it is merely one of many financial metrics that must be considered, the return on capital bears a substantial link to a company’s broader business performance.

First, I will look up the annual report or 10-k for Cisco and highlight all the data we need to calculate our formula. The third item is the most important thing; we want to know how much money we can earn in the future and how the company will need to invest to achieve those earnings. Therefore, the ROIC concept reflects the rate of return generated by a company using the funds contributed by its capital providers.

We exclude the debt from the formula because the other half of the magic formula includes enterprise value, long-term and short-term debt, and any interest paid or accrued due to the leverage. Now that we understand what return on capital is, let’s dive in and discuss the importance of this metric. In his seminal book “The Little Book that Beats the Market,” Joel Greenblatt laid out his now-famous “Magic effective annual rate ear Formula,” included in the formula is his version of return on capital. Yes, Goodwill and DTA/DTL are included in invested capital, and what we mean by ‘operating’ would include anything that goes into invested capital. Since the invested capital is declining while the revenue and NOPAT are growing at a higher pace, the ROIC is rising because more value is being derived from the invested capital.

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