Company's Financial Accounting
Relationship between ROIC % and WACC %
Weighted Average Cost of Capital (WACC %)
DEFINITION:
- WACC or weighted average cost of capital (in Finnish, painotettu keskimääräinen pääomakustannus) is a financial metric used to measure the firm's cost of capital.
- A company's assets are usually financed by both debt and equity. WACC is a combination of the company's costs of these sources of financing.
- WACC is used by analysts and investors to assess the returns on an investment (ROI) in a company.
- WACC is the minimum return a company must earn on its existing assets' base to satisfy its investors, creditors and owners.
- WACC is the average rate that companies are expected to pay to finance their overall operations. The amount the enterprise pays to operate must approximately equal the rate of return (RoR or Return on Invested Capital (ROIC)) it earns.
How to calculate:
The formula for calculations:
WACC = E / (E + D) * Cost of Equity + D / (E + D) * Cost of Debt * (1 - Tax Rate)
WHERE:
- E - the market value of equity or "Market Cap"
- D - the market value of debt or book value of debt
- V = E (equity) + D (debt) - total value of capital
- Weight of equity = E / (E + D): the proportion of equity-based financing
- Weight of debt = D / (E + D): the proportion of debt-based financing
Cost of Equity (rate of return) calculation
Cost of Equity (rate of return) = Risk-Free Rate of Return + Beta (β) of Asset * (Expected Return of the Market - Risk-Free Rate of Return)
WHERE:
- The risk-free rate = the 10-Year Treasury Constant Maturity Rate
- Beta (β) is a measure used in fundamental analysis to determine the volatility (frequency of price change) of a security or a portfolio in comparison to the overall market.
- Expected Return of the Market - Risk-Free Rate of Return = Market Risk Premium
Cost of Debt calculation
Simplified Cost of Debt = Total Interest Expense for the last fiscal year / Two-year average of Book value of Debt
After-Tax Cost of Debt = Cost of Debt x (1 – Tax Rate)
Return on Invested Capital (ROIC %)
DEFINITION:
ROIC (in Finnish, sijoitetun pääoman tuotto) is the overall return on all invested capital, also called ROC (return on capital). Return on invested capital (ROIC) indicator:
- Measures the efficiency of the investment of the company or investments' productivity; how well a company is using its capital to generate profit or returns?
- Measures how well a company generates cash flow relative to the capital it has invested in the business.
- Profitability ratio; the percentage of conversion of capital into returns by the company.
- Helps in a company's growth evaluation.
How to calculate:
The formula for calculations:
ROIC = Net operating profit after tax (NOPAT) / Invested Capital
ROIC = Operating Income * (1 - Tax Rate %) / Invested Capital
ROIC = EBIT * (1-tax rate)/Invested Capital
WHERE:
- Invested capital - sum of all debt and equity on the company's balance sheet.
ROIC % vs WACC %, RESULT INTERPRETATION:
Company's return on invested capital (ROIC) is comparing to weighted average cost of capital (WACC) to understand:
- whether to invest in a particular company;
- whether invested capital is being used efficiently;
- whether the company is considered a value creator or a value destroyer.
When comparing ROIC % with the most widely used metric for cost of capital - WACC % (company’s Weighted Average Cost of Capital), the results could interpret as following:
- ROIC > WACC; ROIC above 2% of the company’s cost of capital (WACC +2%): the investment is favorable (profitable), company is creating value; the company earns excess returns; is delivering consistently high returns on the capital; company management is successful in generating revenues; invested capital is used efficiently.
- ROIC < WACC; ROIC falls lower than 2 % of the company’s cost of capital: warning sign; the investment is unfavorable (not profitable), company is shedding value; money is spent without an increase in revenues; there are no excess capital to invest in future growth.
- ROIC = 0: zero excess capital to reinvest into the business and in its future growth.
It is important to analyze the prospects of the company on the basis of the historical ROIC data for the last years. Companies with growing ROIC for at least the past several years are more preferable for investors, and, at the same time, they will avoid to invest in the companies with declining ROIC.