What is a Good ROIC?

Return on Invested Capital (ROIC) is one of the most critical metrics used to evaluate the efficiency of a business in generating returns from its capital investments. It provides insight into how well a company is using its capital to generate profits, which in turn directly impacts its overall value to investors. The question of what constitutes a "good" ROIC is a nuanced one, depending largely on the industry, the economic environment, and the specific company in question.

Setting the Stage with Reverse Thinking:

Before diving into what defines a "good" ROIC, let's consider what it isn't. A low ROIC is usually a red flag for investors. If a company’s ROIC is consistently lower than its cost of capital, it's essentially destroying value. On the flip side, a strong ROIC indicates that the company is generating healthy returns, often reflecting a competitive advantage, operational efficiency, or superior market positioning.

What Makes ROIC So Important?

A key reason ROIC is so widely used by investors is its capacity to provide a more comprehensive view of profitability compared to traditional metrics like return on equity (ROE) or return on assets (ROA). Whereas ROE can be distorted by high levels of debt, and ROA ignores leverage, ROIC balances both equity and debt contributions, offering a more accurate measure of how a business is using its entire pool of capital.

When determining what constitutes a good ROIC, the rule of thumb is to aim for returns that significantly exceed the company’s weighted average cost of capital (WACC). Typically, an ROIC that is 15% or higher is considered excellent, whereas anything below 7% may be worrisome.

Reverse Order: Why Would a Bad ROIC Still Matter?

There are cases where a company’s ROIC might appear poor but still warrants a closer look. For instance, some high-growth tech companies invest aggressively in R&D and infrastructure in their early years, which can suppress their ROIC temporarily. Yet, the long-term prospects might still be stellar if the company has a strong business model and competitive advantage. Amazon, for example, operated with relatively poor ROIC for many years before becoming the giant it is today.

ROIC by Industry: The Context Matters

A "good" ROIC can vary widely from one industry to another. Capital-intensive industries, like oil and gas or utilities, often have lower ROICs simply because they require massive upfront investments. On the other hand, software and tech companies tend to have higher ROICs because they typically operate with lower capital requirements. To put this into perspective, here's a breakdown of average ROIC benchmarks by industry:

Industry	Average ROIC (%)
Software & Technology	20 - 30%
Consumer Goods	10 - 15%
Manufacturing	8 - 12%
Utilities	5 - 10%
Oil & Gas	4 - 8%

The Intersection of ROIC and Growth

A good ROIC is not just about profitability—it’s also a signal of future growth. Companies with high ROICs have the potential to reinvest their profits at attractive rates, creating a compounding effect on future earnings. In contrast, companies with low ROIC may struggle to find profitable growth opportunities, leading to stagnation.

Compounding Returns: How High ROIC Creates Long-Term Wealth

A company that consistently generates an ROIC above its cost of capital is positioned to create value for its shareholders. For example, consider a company that earns a 20% ROIC annually and reinvests 50% of its earnings back into the business. Over time, this reinvestment can fuel exponential growth. The table below illustrates how a high ROIC can lead to long-term compounding growth:

Year	Initial Investment	ROIC (%)	Reinvested Profits	Total Capital
1	$100,000	20%	$10,000	$110,000
2	$110,000	20%	$11,000	$121,000
3	$121,000	20%	$12,100	$133,100
4	$133,100	20%	$13,310	$146,410
5	$146,410	20%	$14,641	$161,051

After just five years, the company’s initial investment has grown by 61% due to compounding returns from a high ROIC. This powerful effect demonstrates why high-ROIC companies can often outperform the market over the long term.

Factors Influencing ROIC

Several factors can influence a company’s ROIC, and understanding these can help investors make more informed decisions:

1. Operational Efficiency: Companies with streamlined operations tend to have higher ROICs as they can generate more profit from each dollar of capital invested.
2. Market Power: Companies with a strong competitive position or monopoly-like status often boast high ROICs as they can charge premium prices or reduce costs.
3. Capital Structure: Companies with a favorable capital structure (a balanced mix of debt and equity) tend to have a more sustainable ROIC over the long term.
4. Capital Intensity: Industries with lower capital intensity (like software) typically exhibit higher ROICs because they don’t need as much upfront investment to generate profits.

The Role of Innovation in Sustaining ROIC

Innovation is a key driver of sustainable ROIC. Companies that consistently innovate and improve their products or processes can maintain high returns, even in competitive markets. For instance, Apple has maintained a high ROIC over the years due to its relentless focus on innovation, allowing it to charge premium prices and dominate market share.

ROIC and Shareholder Value Creation

Ultimately, ROIC is a crucial determinant of shareholder value creation. Companies that earn a higher ROIC than their cost of capital not only create value but also offer the potential for stock price appreciation and increased dividends. On the other hand, companies with a ROIC below their cost of capital may find themselves unable to sustain long-term growth, leading to value destruction.

Risks of a High ROIC

Interestingly, a high ROIC is not always sustainable. Companies with high ROICs often attract competitors, which can erode their returns over time. For example, if a new entrant disrupts the market with a better or cheaper product, it can drive down the profitability of even the most established companies. Therefore, it’s essential to look at competitive moats—barriers to entry that protect high-ROIC companies from being overtaken by competitors.

Conclusion: Defining a Good ROIC

In conclusion, a "good" ROIC depends on a variety of factors, including industry benchmarks, the company's growth stage, and its cost of capital. As a general rule, an ROIC above 15% is considered excellent, while anything below 7% may be cause for concern. However, investors should always consider the bigger picture, looking at factors like competitive positioning, market dynamics, and capital efficiency to make more informed investment decisions. ROIC, when combined with other financial metrics, can provide a powerful lens through which to evaluate a company’s potential for long-term success.