- ROE is a important indicators of a firm’s profitability and potential growth
- There are some pitfalls of using ROE for measuremen - ROE can be increased with debt.
- ROIC corrects ROE's problem - looks at all moneys (by shareholder and lender) invested into company and how much profit the management can generate.
- It is arguably the best way to determine if a company has a moat.
- Investor focused on earnings growth and not ROIC would miss the fact that the earning growth was generated by how much capital (include debt).
- It is very useful as comparisons among companies within sectors. Highest ROIC = making more profits from every dollar invested - often show the biggest share price gain (shown by Joel Greenblatt's Magic Formula)
- Formula
- ROIC = NOPAT / Invested Capital
- NOPAT = Net Operating Profit After Tax = Operating Income * (1 – Tax Rate)
- !!! Operating Profit (aka EBIT) - not include items such as investments in other firms, taxes, interest expenses and other nonrecurring items
- Invested Capital = Total equity and equity equivalent + total debt – excess cash and investments
- Excess cash - cash of a company has that is not required to operate the business. (1) interest income is not part of Operating Income (2) if company with significant cash balance - the divided result might yield too low
- or, we take the total asset and minus out non interest bearing liabilities
Invested Capital = Total Asset - Non Interest bearing current liabilities - Excess Cash - =Fixed Assets + Current Assets – Non-interest bearing Current Liabilities – Excess Cash
- = Fixed Assets + Non-cash Working Capital
- Non Interest bearing current liabilities - account payable (it is capital invested in the business by a company’s suppliers or contractors, not the company itself), deffered revenue and deffered tax.
- Long term investment - it is not operating assets and should be excluded
- Use of ROIC
- If company ROIC > 15% for number of years - it most likely has a moat.
- But a positive spread between ROIC and WACC alone doesn't justify an economic moat. Investors also have to think about the qualitative attributes--high barriers to entry, huge market share, low-cost production, corporate culture, patents, or high customer switching costs--that create an economic moat around a company's profits.
- Compare the efficiencies of companies using ROIC in the same industry to determine which is a better one to invest in.
- ROIC can also be compared to the firm’s cost of capital to conclude whether the firm has collectively invested in good projects. - A company creates value only if its ROIC is higher than itsWACC.
- Cost of Capital
- When company raise capital from owners or lenders, the investor require a return on their investment.
- Stable and predictable company will have a low cost of capital, while a risky company with unpredictable cash flows will have a higher cost of capital.
- Weighted average cost of capital (WACC) - all capital sources - common stock, preferred stock if any, bonds and any other debt - are included the calculation.
- WACC = E/V * Re + D/V * Rd * (1 -Tc)
- E = Market Value of Equity
- D = Market \ Book Value of Debt
- V = Total Value of Firm = E + D
- Re = Required return of equity holders
- Rd = Required return of debt holders
- Tc = Tax rate (cost of debt is tax deductible)
References:-
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