What Does Return On Capital (ROC) Mean?
Return on capital (ROC) is a financial ratio used by sophisticated corporate acquirers in assessing the attractiveness of an investment in an acquisition target. The book definition of the ratio is net operating income after-tax (NOPAT) divided by the book value of invested capital.
A company creates value when the return on capital is greater than the weighted average cost of capital (WACC). When the opposite is true, value is being eroded.
Divestopedia Explains Return On Capital (ROC)
The expected return on capital for an investor is different for the type of capital being deployed and also the estimated risk of the specific investment. In general, investors look for the following rates of return on the different types of capital uses:
- Senior debt and asset backed lending: 3%–9%;
- Mezzanine or subordinated debt: 9%–23%; and
- Equity: 23%+
The higher the real or perceived risk of a transaction, the higher the return on capital required by an investor. Business owners must understand the concept of return on capital if they wish to maximize the value on sale. A great analysis to perform would be a comparison of the actual return on capital in the business versus the company's WACC versus the expected return for an investor as per above.