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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!
Return on Invested Capital (NASDAQ: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.