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Jonathan Goldberg holds an MBA from the Richard Ivey School of Business at the University of Western Ontario. He has a passion for finance and value investing in particular. Other interests include motorcycles, photography, reading (non-fiction), staying fit, surfing and traveling.
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  • ROIC vs. WACC 5 comments
    Jul 8, 2009 2:07 PM

    Over the next couple of posts I will be providing you with the basic knowledge you need in order to understand my value investing methodology. Also, if you haven't done so already you may want to subscribe to my RSS feed so that you receive the posts as they are published (link is to the right). Think of this as a mini-lesson in value investing. Enjoy!
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    Return on Invested Capital (ROIC) is one of the first things I calculate in order to get a sense of whether or not management is taking the company in the right direction. ROIC is essentially the return that the company generates via its invested capital.
     
    While this is obviously a useful metric to compare a company against its peers, as mentioned, I like to use this in order to look inside the company itself and see if management's actions are taking the company in the right direction. In order to do this I compare ROIC against the company's Weighted Average Cost of Capital (OTC:WACC). This is my estimation of the company's cost of capital to the equity and debt holders, on a weighted average basis.
     
    If ROIC is greater than WACC then we can assume that growth adds value. On the other hand, if ROIC is less than WACC then value is actually destroyed as the company invests more capital; for every dollar of investment the company attracts it pays out more than it earns with it. In the latter case we would want to see management improve the company's ROIC before investing any more capital. Ideally, the company would actually sell non-performing assets in order to get ROIC in line with WACC.
     
    Just because a company's ROIC is less than its WACC does not make it a poor investment. If management is committed to divesting non-performing assets and improving the return on the capital currently employed, and you feel there is a great possibility of them succeeding, then it may be just the investment opportunity you have been waiting for.

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Comments (5)
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  • I have a question about the WACC:

     

    Some people use the WACC as the discount factor, when assessing the value of a firm with the DFC (discounting free cash flow) method.

     

    In my opinion, this can lead to a distorted discount factor that is too small, for the risk you take on your investment.

     

    When the cost of capital of debt (for example 5%) is less than the cost of capital of equity (for example 12%), then, with more debt on the balance sheet, the discount factor becomes less, while the risk of the leveraged company becomes higher.

     

    For example: IBM's WACC
    Long-term debt as percentage of capital: 35%
    Tax rate: 29%
    Cost of equity CAPM estimate: 12.7%
    Yield on IBM long bond: 5.6%

     

    So the WACC = 0.35(5.6%)(1-0.29)+0.6...

     

    When the percentage of debt on the balance sheet chances to, lets say, 55%, the WACC will be:

     

    WACC = 0.55(5.6%)(1-0.29)+0.4...

     

    So again, high debt on the balance sheet in this model, means low discount factor, while anybody who is perceiving this firm to be a higher risk on your investment due to leverage, will, of course, use a higher discount factor.

     

    Can anybody explain to me, why I am wrong in my perception that using the WACC (as prescibed by the CFA) as a discount factor in the DFC model, this eventually leads to false interpretation of risk???
    27 Jul 2011, 07:34 AM Reply Like
  • Here's what you're missing: relevering the Beta. When you increase the level of debt, the Beta increases and hence the cost of equity increases. It's not a free lunch to add debt.

     

    Unlevered Beta = Levered Beta / (1+ ( (1 - Tax Rate) * (Net Debt/Equity) ) )
    25 Oct 2012, 05:11 PM Reply Like
  • The critical aspect missed out is Just as JMP10021 has mentioned. As the D/E increases, the equity shareholders will perceive higher risk which will be reflected in the of higher cost of equity(On account of higher Beta). The higher perceived risk will push up the Beta and the overall cost of capital will actually see an increase. If what you have said is true, ideally every company would go in for a 99.99% debt structure, which we know is not possible(Remember Modigliani and Miller?). But It was good to read your comment Mark, made me go back and check the basics. Thanks for sharing :-)
    24 Dec 2013, 01:42 AM Reply Like
  • As mentioned above in value driven companies ROIC will exceed WACC.

     

    However while calculating NPV of free cash flows it is always that ROIC (ie growth rate) is less than Wacc (ie discount rate).
    20 Mar 2013, 06:01 AM Reply Like
  • WACC is commonly used to discount cash flows for a firm that indulges in normal projects. that is, projects that the firm is comfortable with..however, when the firm decides to venture into projects that are unusual in terms of the usual repertoire, then its best to use some other discount factor....ROIC better than WACC is a good starting point for firms which are value driven....has anyone done some research on this?
    30 Jun 2013, 02:31 PM Reply Like
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