Return on Invested Capital
Return on invested capital compares operating profit with the capital used to generate it. It is one of the clearest measures of business quality.
Why this matters for beginners
A company earning more on capital than the cost of that capital creates value as it grows. One earning less destroys value with every expansion.
Main explanation
Invested capital is broadly the debt and equity used to fund operating assets. The return is operating profit after tax divided by that capital.
Comparing the return with the cost of capital is the key step. Growth only helps when the return exceeds the cost.
High returns invite competition, so the interesting question is why they persist. Durable returns usually rest on a specific advantage rather than good conditions.
The measure is less useful for banks and insurers, where capital works differently, and it can be distorted by large intangible assets from acquisitions.
Example using a real company
Operating profit after tax of 60 on invested capital of 300 gives a twenty percent return. If capital costs eight percent, each expansion adds value.
- →Return 20 percent, cost of capital 8 percent: growth creates value.
- →Return 5 percent, cost of capital 8 percent: growth destroys value.
Common beginner mistakes
- ✕Praising growth without checking the return on capital.
- ✕Applying the measure to banks without adjustment.
- ✕Ignoring goodwill from acquisitions in the capital base.
Key terms
- Invested capital
- The debt and equity funding a company's operating assets.
- Cost of capital
- The blended return that lenders and shareholders require.
- Goodwill
- The premium paid above asset value in an acquisition.
Key takeaways
- 01Returns must be compared against the cost of capital.
- 02Growth below the cost of capital destroys value.
- 03Persistent high returns require a specific explanation.
Check yourself
- 01Growth creates value only when returns exceed the cost of capital.
- 02Return on invested capital works equally well for banks.
- 03Acquisition goodwill can distort the invested capital base.
Try the concept on a real company
Compare a high-return company with a capital-heavy one in the Analyzer and consider which one benefits more from reinvesting.
Educational examples only. Not buy or sell recommendations.