What is a Good ROIC Number?

How much is enough when it comes to Return on Invested Capital (ROIC)? That's the million-dollar question every investor asks when assessing a business’s ability to generate value. In this comprehensive exploration of ROIC, we’ll dive deep into what constitutes a “good” ROIC number, why it matters, and how companies can leverage it for sustainable growth. We’ll also examine how investors can use ROIC as a powerful metric to evaluate potential investments. Whether you're a seasoned financial analyst or just dipping your toes into the world of investing, understanding ROIC is crucial for making informed decisions that yield substantial returns.

What Exactly Is ROIC?

Before diving into what qualifies as a “good” ROIC number, it's essential to understand what ROIC is. ROIC stands for Return on Invested Capital, a financial metric that measures a company’s ability to generate profit relative to the capital it has invested in its operations. In simple terms, it answers the question: How effectively is this business using its capital to create value?

The formula for ROIC is straightforward:

$ROIC=\frac{NetOperatingProfitAfterTaxes\left(NOPAT\right)}{InvestedCapital}$ROIC=InvestedCapitalNetOperatingProfitAfterTaxes(NOPAT)​

• Net Operating Profit After Taxes (NOPAT) represents the company's profits excluding the impact of interest payments and non-operating gains or losses. Essentially, it focuses on the core operational efficiency of the business.
• Invested Capital includes equity and debt used to finance the company’s operations. This metric reflects the resources that the company has at its disposal.

ROIC can reveal whether a company is using its resources efficiently and whether its investments are yielding meaningful returns. But the key question remains: What makes a good ROIC number?

The "Good" in ROIC: What Does it Mean?

A good ROIC generally exceeds the company’s Weighted Average Cost of Capital (WACC), which represents the minimum return a company must earn to satisfy its investors and lenders. Essentially, if a company’s ROIC is higher than its WACC, it's creating value. If it's lower, it’s destroying value. The average company typically has a ROIC of around 7-10%.

However, context is everything when determining whether a given ROIC number is good. For example:

• Industry Variations: In capital-intensive industries like utilities, a lower ROIC may still be considered good. On the other hand, in industries with lower capital requirements, like software or advertising, a significantly higher ROIC might be expected.
• Company Maturity: Young, high-growth companies typically reinvest their capital aggressively and might have a lower ROIC in the early stages, while more established companies may see stable or even high ROIC numbers.
• Economic Conditions: During economic downturns, even solid companies may experience lower ROIC. In contrast, during booming times, an artificially high ROIC can be driven by temporary market conditions.

For investors, the magic number often cited as a “good” ROIC is 15% or higher. Companies achieving this level of return are generally considered highly efficient in capital allocation, and investors are likely to see more value generated over the long term.

Why Does ROIC Matter?

ROIC matters because it reflects the efficiency and profitability of a company’s use of its capital. Companies that consistently post high ROIC numbers are typically better at turning their investments into profits, which is a clear indicator of strong management and solid business fundamentals. Here’s why ROIC is a powerful metric:

1. Value Creation: When ROIC is higher than WACC, the company is creating value for its shareholders. This signals that management is deploying resources efficiently.

2. Capital Allocation: ROIC helps investors and managers understand how effectively the company is reinvesting its profits. High ROIC suggests that the company is making wise investment decisions, while low ROIC could indicate poor capital allocation.

3. Profitability: ROIC is closely related to profitability. A business that generates high returns on the capital invested in its operations is likely to be more profitable in the long run.

4. Comparison Across Companies: ROIC allows for apples-to-apples comparisons across companies, regardless of their size. It’s especially useful when comparing companies within the same industry.

Case Study: High vs. Low ROIC Companies

Let’s look at two contrasting examples: a high ROIC company and a low ROIC company.

High ROIC Example: Apple Inc. (AAPL)

Apple is a company that consistently achieves high ROIC. In 2023, Apple had a ROIC of around 30%, which is significantly higher than its WACC of roughly 9-10%. What drives this impressive number?

• Brand Power: Apple’s strong brand allows it to command premium pricing for its products, yielding high margins.
• Efficient Capital Use: Apple excels at turning its profits into additional value. Its reinvestments in research and development (R&D) and innovation consistently pay off in new product launches and market expansion.

Low ROIC Example: General Electric (GE)

General Electric, by contrast, has struggled with ROIC in recent years. For instance, in 2020, its ROIC hovered around 3-4%, far below its WACC of approximately 7-8%. Why is GE’s ROIC so low?

• Capital-Intensive Business: GE operates in highly capital-intensive industries such as aviation and power generation, where the costs of operations and maintaining infrastructure are massive.
• Struggles with Efficiency: GE has faced challenges in efficiently using its capital, with several underperforming business segments dragging down overall returns.

The Lesson?

Investors would have seen much better returns by investing in Apple compared to General Electric over the last decade. High ROIC companies tend to outperform their low ROIC counterparts in the long run, especially when they reinvest their capital wisely.

How to Use ROIC as an Investor

As an investor, ROIC should be one of the top metrics on your radar when evaluating potential investments. Here’s how you can use it effectively:

1. Compare with WACC: Always compare ROIC to a company’s WACC. If ROIC is consistently higher than WACC, the company is creating value.

2. Look for Consistency: Look for companies with consistent ROIC performance over time. A single year of high ROIC might be a fluke, but if a company consistently posts solid numbers, it’s likely a well-managed business.

3. Industry Context: Keep industry context in mind. What constitutes a “good” ROIC can vary significantly depending on the industry. For example, tech companies should generally have higher ROIC than manufacturing companies.

4. Capital Reinvestment: Pay attention to how the company reinvests its capital. A high ROIC company that is reinvesting in growth opportunities is more likely to compound value over time.

What to Watch Out For

There are a few caveats to keep in mind when relying on ROIC:

• Short-Term vs. Long-Term Focus: Some companies may achieve high ROIC in the short term by underinvesting in critical areas like innovation or infrastructure. This can lead to long-term underperformance.

• Accounting Manipulations: Be wary of companies that manipulate their ROIC through accounting tricks, such as selling assets or delaying capital expenditures.

• Fluctuations in Invested Capital: Companies that undergo significant restructuring or acquisitions may see large fluctuations in invested capital, temporarily distorting ROIC.

Conclusion

In conclusion, a good ROIC number is one that consistently exceeds the company's WACC by a significant margin—generally, 15% or higher is considered exceptional. Understanding ROIC and using it as part of your investment strategy can help you identify companies that are truly generating value. Remember, a high ROIC suggests strong management, efficient capital allocation, and potential for long-term profitability, making it one of the most crucial metrics for evaluating businesses.

So, the next time you’re evaluating a stock, remember to ask: What is its ROIC? And is it enough to create lasting value?