This metric simply calculates how much money a company makes (return) on the money it invests into the company (invested capital). It’s essentially the efficiency of the company, and an indicator of how wise your management team is. If they have a high ROIC (>15%), then they are investing efficiently. If they have a low ROIC (<5%), then they are investing inefficiently – they are wasting money on stupid projects. As investors, the returns on our investment will be dependent on the returns in the company’s investments. So this ROIC is somewhat of a proxy for our returns as an investor. High ROICs will give us high returns, and low ROICs will give us low returns (all else being equal). So if you find a high ROIC company at a good price, jump onto it, because these high ROIC companies will go on the cheap very rarely (but they all do at some point), so act fast when they do.
Let’s see why this efficiency matters. Let’s say that a company borrows money at 5% interest, and has a ROIC of 5%. So the company is increasing its debt load to invest in new projects, and those projects are returning 5%. The company has to pay 5%pa on their debt, so all the money they just made on this new project went straight into paying back the interest on the debt. Note that they still have to pay back the principal amount that they borrowed. So if a company kept doing this then they would just gradually increase their debt-load and all the money they’re making is going straight back to the people who lent them the debt. So the company is becoming more and more likely of going bankrupt (due to their increasing debt), and its for no gain to shareholders. This is why efficiency is important.
So as a general rule, never invest in companies with ROIC < 5%. Aim to invest in companies with ROIC of 15+%. You can still invest in the companies with 6-15% ROIC, but note that they aren’t as good. In fact, investors define the quality of a company almost-entirely on the basis of this ROIC. Companies with ROIC greater than 15% are seen as high-quality, while 6-15% are average, and 5% or less is seen as poor-quality.
Note that there’s another similar metric called Return on Equity (ROE). This is essentially the same thing, but it’s calculated after debt is taken out. So it’s the return the company’s projects make for us shareholders, whilst ROIC is the return the company’s projects make for everyone (shareholders and debt-holders). If your company has no (or low) debt, these two numbers will be the same. If your company has high debt, then the ROIC will be higher than the ROE, because they have to pay out a lot to the debt-holders, leaving the shareholders will less.