Calculating Return on Capital
Gather the company's financial statements. The formula for calculating return on invested capital is ROIC = (Net Income - Dividends) / Total Capital. As you can see you're going to need three pieces of information, each of which comes from a different financial statement. The net income is found on the company's income statement. The dividend payout is obtained from the company's cash flow statement. The total capital is calculated from the company's balance sheet.
Get the net income for the year from the income statement. This is typically located on the bottom line. The income statement shown is taken from a prominent public company. It shows that the company's net income for the year ending Dec 31, 2009 was $11,025,000,000. (Note that all numbers in the statement are in thousands.)
Subtract any dividends the company may have issued. Companies don't need to issue dividends, but many of them do. The dividend distribution amount is found on the company's cash flow statement, in the section titled "Cash From (Used By) Financing Activities" (or words to that effect). Dividends are a portion of a company's earnings that corporations pay their shareholders. They're almost always paid in cash, but they can also be paid in stock or other properties. Companies can also choose to retain earnings (to invest back into the company), rather than paying dividends to shareholders.
Determine the total capital at the beginning of the year. You'll get this information from the balance sheet. Add up debt and total shareholder equity (which includes preferred stocks, common stocks, capital surplus and retained earnings). The balance sheet for the company at the beginning of 2009 is shown in the middle column. Using the figures from the balance sheet at Dec 31, 2008, total capital is $330,067,000,000 (long-term debt) + $104,665,000,000 (total shareholder equity) = $434,732,000,000. Also note that only long-term debt is included, as short-term debt by definition is due within one year, so that the company does not have use of the money for the entire year in which earnings are made.
Subtract dividends from net income, and divide by the total capital. This gives you the return on capital. In this example, the return on capital is $11,025,000,000/$434,732,000,000 = 0.025, or 2.5%. This means that the company generated a return of 2.5% on its available capital in the year 2009. The total return on capital takes into account the dividends and the net income transferred to retained earnings.
Making Sense of ROIC
Determine the management effectiveness of the company. ROIC is a measure of how effective a company is at turning investor capital into profit. A company that can consistently generate ROICs of 10% to 15% is great at returning invested money to its stock- and bond-holders. When looking at companies to invest in, this ratio can be very helpful. Look for high ROICs. The higher the ROIC, the better the company is at taking money and turning it into profit.
Use ROIC to separate the bad stocks from the good stocks. Let's say a company with $500,000 net income takes on $10 million in debt. The company then proceeds to earn $1 million in net income, thereby increasing their net income by 100%. If you looked only at earnings growth, you wouldn't notice that it took the company $10 million to create that $1 million growth. Their ROC of 10% isn't very impressive. This may be a helpful analogy: Think about basketball players. You might think that a player who averages 15 points on 20 shots per game has a great game if he scores 30 points. But if you notice that he took 60 shots to get those 30 points, you might not think he had such a great game after all, because he was actually less efficient than usual in his shooting. ROIC works the same way. In the basketball analogy, ROIC would be telling you how efficient a player is at scoring.
Use ROIC instead of other ratios. Return on capital is a better measure of investment return than are either return on equity (ROE) or return on assets (ROA). That's because those other ratios are based on incomplete or possibly inaccurate data. Regarding ROE, if you put in $1000 to start a business, borrow $10,000, and make $500 after one year, your ROE is a generous $500/$1000, or 50% per year. This seems too good to be true. Well, it is. The actual return on invested capital is $500/($1000+$10,000) = 4.55%, a more reasonable figure. ROA is unreliable. That's because of the difference between an asset's cost and its market value at any given moment in time.
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