The GuruFocus site gathers together a wide variety of information and calculations that investors can use to help determine whether or not investing in a specific stock is the right choice for them.
Of these calculations, two are often used side by side to evaluate whether a company is creating or destroying value for its shareholders. These are the return on invested capital (ROIC) and the weighted average cost of capital (WACC).
ROIC
The ROIC measures how well a company generates cash flow relative to the capital it has invested in its business. In other words, it reveals how much a company is earning in excess of what it paid in order to produce those earnings.
A company with a history of generating positive excess returns is more likely to continue growing value for shareholders as its business grows. When considered by itself, a ROIC above 2% is thought to be indicative of value creation, while a ROIC below 2% is thought to signal value destruction.
There are multiple different methods that are frequently used to calculate the ROIC, all centering around dividing the sum of a company's returns by the sum of capital invested. GuruFocus calculates the ROIC as follows:
“ROIC = NOPAT / Average Invested Capital,” in which NOPAT is the net operating profit after tax and the Average Invested Capital is the average of the invested capital (i.e., Total Assets - Accounts Payable & Accrued Expense - Excess Cash) over the past two years.
WACC
Also referred to as the cost of capital, the WACC is the rate that a company is expected to pay on average to all its security holders to finance its assets. Most companies finance their assets with a combination of debt and equity, and every source of a company’s financing typically has its own costs.
The WACC is the average of the costs of all of a company’s sources of financing, with each source weighted by its respective use. Taking the weighted average lets us see how much interest the company has to pay for every dollar it finances. Sources of capital that a company can utilize include but are not limited to: common stock, preferred stock, bonds and any other long-term debt.
Calculations for WACC involve multiplying the costs of equity and debt sources of capital by their respective weights, then adding the products together to determine the overall value. GuruFocus calculated the WACC as follows:
“WACC = (E / (E + D) * Cost of Equity) + (D / (E + D) * Cost of Debt * (1 - Tax Rate),” in which E stands for equity and D stands for debt. “E/(E+D) * Cost of Equity” refers to the weighted value of equity-linked capital, while “D / (E + D) * Cost of Debt * (1 - Tax Rate)” is the weighted value of debt-linked capital.
Uses and pitfalls
ROIC and WACC can both be useful to investors by themselves. The ROIC can help determine if a company is generating a positive return on investments, while the WACC is commonly used as a discount rate for future cash flows in DCF analyses.
However, these two calculations can be especially useful when compared to one another. If the ROIC is higher than the WACC, it indicates that the company is creating value for shareholders as it grows. Meanwhile, if the ROIC is lower than the WACC, it indicates the company is destroying value.
On the GuruFocus site, the comparison of ROIC and WACC for the trailing 12-month period can be found in the “financial strength” section of a stock’s summary page:
Users can also search the ROIC-WACC comparison in the interactive chart. The advantage of the interactive chart is that you can search for the annual or quarterly comparison throughout the company’s history, not just for the most recent period. Below is the annual ROIC and WACC chart for Apple Inc. (AAPL) over the past few decades:
If a company has consistently demonstrated a higher ROIC than WACC over the years, it strengthens the likelihood of continuing to create value for shareholders. Investors can also keep an eye out for declining ROIC or increasing WACC, either of which can indicate that the company is becoming increasingly inefficient in terms of generating returns on its investments.
However, just like with any calculation, ROIC and WACC can in some cases be rendered useless if one or more of the component values is zero or negative. This happens more often with WACC, which has more variables at play.
Sharp increases or decreases in net operating income or taxes can sometimes result in wild changes in ROIC. This is more likely to occur with companies that are in their early stages, especially loss-making tech startups. Companies that see their ROIC whipsawing from 100% to -200% over the course of a single quarter are typically new, unproven and high-risk investments, and bull cases for such stocks are mainly built around expectations for future success.
