Cash Return on Capital Invested: A Comprehensive Guide

Understanding cash return on capital invested (RCI) is crucial for businesses to make informed decisions about investments and resource allocation.

Cash RCI measures a company's return on its investments in terms of cash generated, not just profits.

A cash RCI of 1 means a company generates as much cash as it invests, while a cash RCI below 1 indicates a company is not generating enough cash to cover its investments.

In a perfect world, a company would aim for a cash RCI of 1 or higher to ensure it can cover its investments and grow sustainably.

However, achieving a cash RCI of 1 is not always possible, and companies must weigh the costs and benefits of investments to make informed decisions.

Cash return on capital invested (ROIC) is a financial metric that measures a company's ability to generate profits from the capital invested. It's calculated by dividing net operating profit after taxes (NOPAT) by invested capital.

NOPAT is a critical component of ROIC, and it's calculated by taking the company's EBIT and adjusting it for taxes. This is done by multiplying EBIT by (1 – Tax Rate %). The resulting figure represents the company's operating income after taxes.

Invested capital, on the other hand, is the sum of fixed assets, net working capital, and acquired intangibles, including goodwill. This figure represents the total amount of capital invested in the company.

Here's a simplified way to calculate invested capital: add net debt (gross debt minus cash and cash equivalents) to equity from the balance sheet. This approach ignores debt and interest-bearing securities as they're not considered operating liabilities.

While calculating invested capital can be straightforward, there are some challenges when it comes to acquired intangibles and goodwill. These premium payments reflect management's capital allocation decisions, but the value of unacquired intangible assets can be difficult to determine.

The basic formula for ROIC is simple: you use the book value of each item in the denominator, not its market value. This means you should use the value of each item on the Balance Sheet, not its market value.

ROIC, or Return on Invested Capital, represents the efficiency at which a company uses its capital to generate profitable returns on behalf of its shareholders and debt lenders.

To calculate ROIC, you need to compute NOPAT (or EBIAT), calculate Average Invested Capital (IC), and then divide NOPAT by Average Invested Capital.

NOPAT Calculation is a key step in calculating ROIC, and it's based on the company's revenue and operating income (EBIT). The NOPAT margin is NOPAT as a percentage of revenue, and it expanded from 17.5% in Year 0 to 23.3% in Year 5.

Invested Capital Calculation is also crucial, and it represents the net operating assets used to generate cash flow. Net working capital (NWC) is calculated by subtracting current liabilities (excluding debt and interest-bearing securities) from current assets (excluding cash & cash equivalents).

The ROIC ratio quantifies the profits that the company can generate for each dollar of capital invested in the company in a percentage. The two common sources of funds for companies that are used to invest in cash flow generative assets and derive economic benefits are debt and equity.

Here's a simple example of calculating ROIC: 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. The ROIC comes out to 10%, which means the company generates $10 of net earnings per $100 invested in the company.

The ROIC concept reflects the rate of return generated by a company using the funds contributed by its capital providers. Since the return metric is presented in the form of a percentage, the metric can be used to assess a company's profitability as well as make comparisons to peer companies.

The formula for Cash Return on Capital Invested (CROCI) is straightforward: CROCI equals EBITDA divided by Total Capital Value. This ratio measures a company's ability to generate cash profits relative to its total capital investment.

EBITDA, or Earnings before interest, taxes, depreciation, and amortization, captures the recurring core operating profits of a company. It's an unlevered measure, unaffected by the capital structure, making it a reliable metric for comparing companies.

The two core components of the Return on Invested Capital (ROIC) calculation are NOPAT and invested capital. NOPAT, or "EBIAT", is the tax-affected operating income of the company, while invested capital is the sum of fixed assets, net working capital, and acquired intangibles, including goodwill.

Here's a breakdown of the components that make up the ROIC metric:

The higher the profit margins of a company, the higher the return on invested capital, as the company can convert more revenue into profits, or NOPAT, to be more specific.

Return on Equity (ROE) is a metric that measures a company's profitability by comparing its net income to its shareholders' equity. It's a key performance indicator that helps investors and analysts assess a company's ability to generate returns on the capital invested by its shareholders.

ROE is closely related to Return on Assets (ROA), which measures a company's profitability based on its total assets. While ROA focuses on the company's overall efficiency, ROE specifically looks at the returns generated by the shareholders' equity.

To calculate ROE, you need to know a company's net income and its shareholders' equity. The formula is simple: ROE = Net Income / Shareholders' Equity. For example, if a company has a net income of $5 billion and shareholders' equity of $20 billion, its ROE would be 25%.

A high ROE indicates that a company is generating strong returns on the capital invested by its shareholders. Conversely, a low ROE may suggest that a company is not efficiently using its equity to generate profits.

Here's a simple equation to illustrate this:

In this example, the company with a 25% ROE is generating more profits from its shareholders' equity compared to the company with a 10% ROE.

The ROIC formula is made up of two main components: NOPAT and invested capital. NOPAT, or net operating profit after tax, is the tax-affected operating income of the company, calculated by multiplying EBIT by (1 minus the tax rate).

Invested capital, on the other hand, is the sum of fixed assets, net working capital, and acquired intangibles, including goodwill. It can be calculated using the formula: Invested Capital = Fixed Assets + Net Working Capital (NWC) + Acquired Intangibles + Goodwill.

Here's a breakdown of the key components of invested capital:

It's worth noting that the value of acquired intangibles and goodwill can be subjective and may vary depending on the company's accounting practices.

Cash return on capital invested is a valuable metric for evaluating a company's financial performance and making informed investment decisions. It helps you understand how much money is required to generate gains.

The formula for cash return on capital invested is simple: divide EBITDA by the total value of a company's equity and other forms of capital. This ratio indicates how well a company is performing in terms of cash flow.

A higher ratio of cash returned from investments is a sign of a company's success. In fact, a company with a 50% return on invested capital can reinvest its proceeds to turn the investment into $1.50, while a company with a 25% return on invested capital can only turn the investment into $1.25.

To use cash return on capital invested in decision-making, you can compare it with other valuation multiples, such as the price-to-earnings (P/E) or enterprise value-to-EBITDA (EV/EBITDA) ratios. This will give you a more comprehensive view of a company's financial health and potential for growth.

Here are some key benefits of using cash return on capital invested in decision-making:

By incorporating cash return on capital invested into your investment decision-making process, you can make more informed choices and potentially achieve better returns on your investments.

Cash Return on Capital Invested (CROCI) is a financial metric that measures a company's profitability by comparing its cash flow to its invested capital. CROCI can be used to compare the performance of different companies, sectors, or markets, but it's not without its limitations.

CROCI may not reflect the true economic value of a company, as it's based on accounting data that may not capture actual cash flows or capital invested. This can lead to distorted CROCI ratios and make comparisons across companies or industries unreliable.

CROCI can be influenced by accounting policies and assumptions, which may vary depending on the accounting standards, methods, and assumptions used. This can make CROCI inconsistent or unreliable over time or across companies.

CROCI does not account for the cost of capital or the growth potential of a company, which are important factors for investors. A high CROCI may not necessarily indicate a company's value creation or growth potential.

While CROCI has its limitations, it can still be a useful tool for investors to identify undervalued or overvalued stocks. However, it's essential to consider these limitations when using CROCI for cash flow analysis.

Cash return on capital invested (CROCI) is a powerful metric that can help investors evaluate a company's efficiency and value creation. It's calculated by dividing net operating profit after taxes (NOPAT) by invested capital, and it can reveal a company's strengths and shortcomings over time.

In the airline industry, CROCI can help investors identify which companies are more likely to generate sustainable cash flows and create value for shareholders. For example, in 2019, Southwest Airlines had a CROCI of 15.6%, while Delta Air Lines had a CROCI of 12.4%, and American Airlines had a CROCI of 6.9%.

Here are some real-world examples of CROCI in different industries:

These differences reflect the different business models, strategies, and challenges of each company, and CROCI can help investors make more informed decisions about which companies to invest in.

In the airline industry, CROCI can help investors evaluate which companies are more likely to generate sustainable cash flows and create value for shareholders. For example, in 2019, Southwest Airlines had a CROCI of 15.6%, while Delta Air Lines had a CROCI of 12.4%, and American Airlines had a CROCI of 6.9%.

CROCI can also help investors compare the performance of different companies or industries based on their cash generation efficiency. This is particularly useful in industries with high fixed costs and low margins, such as the airline industry.

The pharmaceutical industry is another area where CROCI can be applied. Companies in this industry face high research and development costs, long product development cycles, and patent protection, making it difficult to measure their true profitability and value creation.

In the retail industry, CROCI can help investors assess the effectiveness of investments in stores, inventory, and online platforms. For example, in 2019, Walmart had a CROCI of 8.7%, while Target had a CROCI of 7.9%, and Amazon had a CROCI of 5.4%.

Here are some real-world examples of how CROCI can be used for cash flow analysis:

These differences reflect the different business models, strategies, and market positions of each company, as well as their investment in innovation and growth.

LBO and DCF Models are essential tools in investment banking, but they require careful consideration of key metrics.

A sanity check for long-term forecasts can be done using the ROIC metric in LBO and DCF models.

If you assume a higher exit multiple, the company's ROIC should increase over the holding period.

In a 3-statement model for Coles, a grocery retailer in Australia, a higher exit multiple (~10x to ~12x) is justified by an increase in ROIC from ~15% to ~20%.

In a DCF model, you generally want the ROIC to decline and move closer to the company's WACC over time.

The ROIC should not remain high indefinitely against a much lower WACC, such as 10 – 12%.

Even if the company's ROIC is high initially, such as 30 – 12%, it should be closer to WACC by the Terminal Period.