Capital Investment: Understanding Its Meaning and Methods for Estimating Returns (Return on Invested Capital, or ROIC)
What's the Lowdown on Invested Capital? An Unfiltered Guide
Let's get real about invested capital - the essential cash that a business raises to roll in its operations and growth. This moolah comes from issuing new securities to investors (equity), borrowing dough (debt), or any combination thereof. So, what's the lowdown on this lifeblood of business finance?
Invested Capital Demystified
Invested capital is the total amount of dough pouring into a company from equity and debt sources. Think of it as the capital injection that businesses need to secure assets, expand, and rake in profits. A company's return on invested capital (ROIC) will give you a sense of how well they're using their invested capital to make a profit - and it's not found on corporate financial statements because each section - debt, capital leases, and stockholders' equity - is listed separately on a company balance sheet.
Key Takeaways
- Invested capital is the sum of all the money a company raises via equity and debt.
- It fuels the growth and ongoing operations of a company.
- Companies use it to purchase assets and generate profits.
- ROIC is a vital metric to assess how well a company uses its invested capital.
Grasping Invested Capital
For a company to thrive, it needs to generate more earnings than the cost to raise the capital provided by bondholders, shareholders, and other financing sources, or else it doesn't make an economic profit.
To measure how well a company uses its capital, businesses employ various metrics, such as return on invested capital, Economic Value Added, and Return on Capital Employed.
The Capitalization See-Saw
When a company releases new securities – like stocks or bonds – the total capitalization increases. In IBM's example, issuing 1,000 shares of $10 par value stock at a price of $30 per share increases the common stock balance for the total par value of $10,000, and the remaining $20,000 received increases the additional paid-in capital account. On the other hand, if IBM issues $50,000 in corporate bond debt, the long-term debt section of the balance sheet increases by $50,000. In total, IBM's capitalization rises by $80,000, thanks to issuing both new stock and new debt.
Earning a Return on Capital
A successful company maximizes its return on the capital it raises, and investors pay close attention to how businesses use the proceeds from issuing stock and debt. If a plumbing company, for instance, issues $60,000 in additional shares of stock and uses the sales proceeds to upgrade plumbing trucks and equipment, the company's earnings increase, enabling it to pay a dividend to shareholders. The dividend boosts each investor's rate of return on a stock investment, and investors also cash in on stock price increases fueled by increasing company earnings and sales.
Companies may also use a portion of earnings to repurchase stock previously issued to investors, retire the stock, and reduce the number of shares outstanding. This lowers the equity balance, and analysts pay extra attention to a firm's earnings per share (EPS), or the net income earned per share of stock. If the business repurchases shares, the number of outstanding shares decreases, which means that the EPS increases, making the stock more appealing to investors.
Return on Invested Capital (ROIC)
The return on invested capital (ROIC) formula is used to evaluate a company's efficiency in allocating its capital to profitable investments. This calculation gives a sense of how effectively a company is using its money to generate returns. ROIC is calculated as:
[\text{ROIC} = \frac{\text{Net Operating Profit After Tax (NOPAT)}}{\text{Invested Capital}}]
where NOPAT = Operating Profit × (1 – Effective Tax Rate)[1].
Comparing a company's ROIC to its weighted average cost of capital (WACC) reveals whether invested capital is being used effectively. This measure is also known simply as return on 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. If ROIC is greater than a firm's weighted average cost of capital (WACC), the most common cost of capital metric, value is being created, and these firms will trade at a premium. A common benchmark for evidence of value creation is a return of over 2% of the firm's cost of capital. If a company's ROIC is less than 2%, it is generally thought to be a value destroyer.
The ROIC-WACC Connection
WACC is the average rate a company pays to finance its assets, weighted between debt and equity costs. Comparing ROIC to WACC is crucial for value creation assessment - if ROIC > WACC, the company generates returns above its capital costs, indicating value creation and a healthy, sustainable business model. However, if ROIC < WACC, the company fails to cover its cost of capital, suggesting value destruction, and potentially an unsustainable business.
This relationship between ROIC and WACC emphasizes the importance of efficiently utilizing available resources to ensure profitability and value creation.
Calculating Capital Invested
The formula for calculating capital invested is:
Capital Invested = Total Equity + Total Debt (including capital leases) + Non-Operating Cash.
Capitol Invested in Action
When a private company decides to go public, has an initial public offering, and sells a million shares to raise $17 million, that constitutes capital invested. Similarly, if a company decides to sell $10 million worth of bonds with a coupon of 3%, that's capital invested too. Capital investments generally involve land, buildings, and equipment[1].
What Makes a Good ROIC?
A healthy return on invested capital (ROIC) is usually considered to be 2% and above. Conversely, a business is generally perceived as destroying value if it has an ROIC of less than 2%.
The Final Word
Invested capital is the crucial cash a company raises through the sale of shares and the issuance of bonds; a mix of both equity and debt financing. A company can have either just equity financing, just debt financing, or a combination of both. Businesses raise capital to finance their needs, such as growth, maintenance, and expansion.
- Companies use the return on invested capital (ROIC) as a crucial metric to assess how effectively they are using invested capital to generate profits, with a healthy ROIC often considered to be 2% and above.
- A successful company maximizes its return on the capital it raises, and investors pay close attention to how businesses use the proceeds from issuing stock and debt.
- The capitalization of a company can increase when it issues new securities like stocks or bonds, or when it takes on debt, and understanding this process is crucial for personal-finance and DeFi investors who want to invest in businesses.
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