There are many coefficients and approaches investors use to undertake equity valuation. But before investors start the time-consuming fundamental analysis, there is one Important coefficient every investor should pay attention to. I use this coefficient to answer whether it is worth analyzing the company or if I should switch to the other company from the peer group. This coefficient is ROIC or return on invested capital. Let me first start with its components, and then I will tell you how to use them to define good companies.
Companies can use different sources of funding. One of the most well-known is borrowing money from the bank, issuing bonds, or issuing stocks. ROIC compares companies' profits to the volume of funding attracted by the company. It is done to see whether the company is generating profits on its attracted funding. And investors examine this figure to see if the company is making some profits on its attracted funds. The higher the ROIC, the better it is. The formula for calculating ROIC is EBIT (earnings before interest and taxes) divided by the among of attracted capital. The attracted capital, in this case, is a shareholder's equity, attracted debt, both from the banks and from the bonds issue, and other interest that can arise from the borrowing of funds. Now let's consider how financial analysts and traders can use ROIC.
ROIC is used in two major ways. First, compare ROIC to the companies of the closest peer group. If your selected company's ROIC is higher than that of peer group companies, your selected company is better. If it is less, other companies generate a higher return on attracted funding. But in any case, please don't rely only on one ratio. It would be best to make a complex examination and apply custom ratios to evaluate your selected company from different angles. Still, the ROIC is one of the most critical indicators. Second, investors compare the ROIC against the cost of capital or WACC. WACC is the weighted average cost of capital.
In a simple word, WACC examines the cost of attracted funds, including bank borrowings, debt issues, and stock issues. To calculate the WACC, first, you need to find the rate at which the company attracted the funding from the bank and the rate at which the company is paying its bondholders. Then calculate what the cost of equity was. The formula for the cost of equity is the risk-free rate (an average rate of US treasury yield across different maturities) plus stock Beta, multiplied by the market return minus the risk-free rate.
Cost of equity formula = Rf + B * (Rm - Rf).
When you finish computing the cost of equity and the cost of debt, the next step is to find the total funding, equity plus debt plus bond issue volume. And then find the portion of equity funding and the portion of debt funding. Own funds and borrowed funds. The last step is to calculate the weighted average cost by the formula.
WACC = Cost of debt * portion of debt + cost of equity * portion of equity.
When you computed the WACC, it is time to compare it to the ROIC. If the ROIC is higher than the WACC, it is good. It tells that company's cost of funding is lower than the return it is making from its invested capital. If you want to understand those figures better and learn fundamental analysis and equity valuation, you can take my course to be confident in your analysis.
When you use the ROIC, it is best to calculate it on a yearly basis (from the annual financial reports) and compare it to the WACC on a yearly basis. The quarterly numbers can be very volatile and can mislead you in your analysis. It is also good to compare your ROIC and WACC from year to year to see the dynamics. Stable figures are better than rapidly fluctuating figures. If you see the stability, it would mean that the company can better control its spending and funding. If you see a rapid rise or decline in the ROIC vs. WACC, it is a good idea to examine the figure more closely, read the company's financial reports and examine what caused the significant fluctuation. Please also remember that you should consider other indicators before making your final decision. Still, if WACC exceeds the ROIC and if you see large fluctuations, it is time to ask additional questions or switch to the other company from the peer group. As I have said earlier, for me, this comparison serves as a starting point for my analysis. If I am satisfied with the result, I will start my equity valuation. I can use different models such as DCF, DDM, or price-income to calculate stock target price, but before beginning this analysis, I always check ROIC to WACC.
Thank you for reading my blog. If you have additional questions or suggestions, don't hesitate to contact me. Email: skobzhan@diversset.com