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Breaking Down ROIC

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By imuafool
September 18, 2009

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Joe (TMFValuemoosie),

Thanks for sharing your 2-part posts.

Way back on 9/27/00, Andrew Chan, one of my all-time MF favorites who no longer participates on any TMF message boards, posted the most comprehensive and still one of the best articles on ROIC. Since 2000, TMF staff have written various versions of Chan's original article.

In his original article, Andrew Chan stated the importance of Weighted Average Cost of Capital (WACC), i.e., so important that without WACC, ROIC is not very useful.

Before I move on with further insights on ROIC, another concept must be introduced: the weighted average cost of capital (WACC). For without the WACC, ROIC is not very useful. The WACC represents the minimum rate of return (adjusted for risk) that a company must earn to create value for shareholders and debtholders. ROIC is measured against the WACC, which is what makes it such an important concept.??

When the ROIC is greater than the WACC, it means that the firm creates value; otherwise it destroys value. In practice, a company with a ROIC of 25% and a cost of capital of 11%, has created 14 cents of pure economic value for every dollar invested. The difference between ROIC and WACC is called the ROIC-WACC spread (%), which is one of the most important valuation tools in securities analysis (For more information on the WACC, please read Dale Wettlaufer's Equity Isn't Free).??

So what does all this mean for investors? To start with, Fools would be better off tracking ROIC-WACC spreads than EPS, net income or ROE. Studies have shown that stock prices are highly correlated with ROIC-WACC spreads. Value creation is the key, simply looking at EPS or net income does not indicate whether a company creates value or not. In some cases, even high sales growth can be harmful as new capital is being invested in value-destroying projects. EPS, net income, and growth does not tell how much capital was required to generate those numbers, which is a fundamental flaw in using these traditional metrics.

Joe and others, I would appreciate your feedback on Andrew Chan's statement above. I've found calculating ROIC a daunting task, and calculating WACC impossible. Past posts and articles by TMFers attempting to calculate WACC have been very shallow, overly simplistic, and basically not very helpful. If calculating ROIC involves making what Joe referred to as judgment calls, calculating WACC deals with so many variables and also requires making judgment calls. I've seen ROIC data provided on the Million Dollar Portfolio premium board, but no associated WACC data mentioned at all.

Perhaps, TMF believes that ROIC is good enough, and WACC is unnecessary. If untrue, Joe would you please consider taking us through WACC calculations for Starbucks and determine ROIC-WACC spreads?