Welcome to the fifteenth Pari Passu newsletter,

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Today, we will learn more about:

1. Introduction to ROIC

If you think you know all about this, let’s make a bet. If you read everything and you do not learn anything, you can unsubscribe. But if you learn something, you will send this post to a friend. Jokes aside, this is interesting so let’s get to it.

How to calculate ROIC

Let’s start from the basic that most of you probably know, return on invested capital (ROIC) is defined as = Net operating profit after taxes (NOPAT) / Invested capital (IC)

The idea of this metric is to understand whether a company is creating value with its investments. Using capital for investment presents an opportunity cost (what other return could I generate with that capital, also known as WACC) and therefore the idea is to compare the return generated by investing in the company with my opportunity cost. Let’s see this was a basic example.

A company invests $10,000 and the opportunity cost is 8 percent. In the first scenario, the investment generates a cash flow of $500 per year into perpetuity, which equals a value of $6,250 ($500/.08). This example illustrates why positive earnings do not always equate to value creation. In fact, we would be better off avoiding this business and investing our money at 8 percent. In this case, growth is not helpful unless growth enables a higher return on capital compared to current levels.

In the second scenario, the business earns $800 in cash flow per year, making the investment worth exactly the cost of $10,000 ($800/.08). This business is value neutral (meaning it does not create or destroy capital). In this case, growth does not affect value creation (In this case, growth is good (as long as return on capital stays constant).

In the final scenario, the firm produces a cash flow of $1,100. This company creates value, as the $10,000 is worth $13,750 ($1,100/.08). In this case, growth is good (as long as the return on capital stays constant). The faster the company can grow while sustaining these returns, the more value it creates.

How to calculate net operating profit after taxes?

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