Return on Invested Capital is a profitability or performance measure of the return earned by those who provide capital, namely the firm’s bondholders and stockholders. Return on Invested Capital (ROIC) can be defined as follows:
Return on Invested Capital formula image
There are three key insights to be gained from this definition:
We use after-tax operating income (NOPAT) rather than net income because it must consider earnings to not only stockholders (net income), but also to bondholders (interest).
We use the book value of debt and equity rather than the market value because market value incorporates expectations for the future, but book value removes these expectations to more accurately indicate current profitability. Furthermore, we net out cash because the interest income from cash is not a component of operating income.
We account for the timing difference, as the capital must first be invested before the invested capital begins generating earnings. Some analysts will opt to take an average of the invested capital amount in the prior and current periods.