We just looked at the unfortunate case of Wallace's Widgets (Ticker: WIDGT), whose return on capital steadily dwindled as it sank ever more cash into ever-less-profitable projects.
In the fifth and final year of our example, the company had after-tax operating earnings of $249 and was barely beating its cost of capital. At this point, the company had $3,277 in invested capital, which we'll assume came half from equity capital and half from debt.
If investors only considered the cost of debt, it would look like the company was adding value to the capital at its disposal. Earnings before interest and taxes in year five would be $383 ($249 in earnings / (1 - 35% tax rate)), much higher than the cost of debt. With $1,639 in debt, the company's interest expense (using an 8% loan rate) would be $131 in year seven, giving the company 2.9 times interest coverage, well within the comfort zone. After a tax savings of $46 (35% of interest expense -- in short, the company's tax rate times its interest expense) that the company receives from using debt rather than equity, the cost of debt capital is $85.
Time to pay the piper
But even though the cost of equity does not show up on a company's income statement, it's not free. Investors expect a rate of return on equity, one that's in line with the S&P 500 and takes into account the specific risks of the company in question.
In this case, Wallace's Widgets has an average debt-to-equity ratio of 1 in year five; it may also be operating in a slower-growth industry with poor economics to begin with. In that case, we would demand a rate of return on equity of about 1.2 times the S&P 500's historical 10% return -- 12% -- to compensate for the extra risk. A lower return on equity will hurt the valuation of the company's equity, and ultimately diminish the multiple the market will pay for all the capital invested in the business, as well as its earnings and cash flow.
Again, we assume the company has $1,638 of equity in use. At 12% (the company gets no tax savings on this, since earnings attributable to equity are taxable), the cost of equity in use over the course of the year is $197. Combined with the after-tax cost of debt, the company's total cost of capital is $282 -- higher than its after-tax operating earnings.
We can prove this by calculating the company's weighted average cost of capital on a percentage basis. With capital of $3,277 and 50/50 equity and debt, half the capital costs 12%, and the other half costs 5.2%, both after tax. Let's work out the weighted average cost of capital (WACC):
(0.5 x 12%) + (0.5 x 5.2%) = 8.6%
Multiplying WACC by average total capital for the year, the company's cost of capital was $282.
In this case, Wallace's Widgets should trade below the value of its capital, because it will continue to destroy value. Because the WACC of 8.6% is greater than the ROIC of 7.6%, the business will eventually sap away all shareholders' equity, and its creditors will end up taking control.
ROIC alone can't tell you how well a company is operating. Fools should instead study it in relation to a company's cost of capital. Many companies and leveraged buyout firms have operated on this system, called Economic Value Added, or EVA, for a number of years. While this philosophy alone doesn't guarantee success, some of the biggest generators of shareholder value have embraced it. In our example, Wallace's Widgets would have stopped growing at a certain point to preserve shareholder value, forgoing growth for growth's sake, and devoting more of the value of its enterprise to its creditors than its shareholders.
When ROIC starts to drop, investors should pay attention. Falling ROIC can signal anything from a momentary blip in the company's progress to decay in industry or company fundamentals. Successful companies in more mature industries -- the characteristics defining success for companies in hypergrowth industries are much different -- generate ROIC above and beyond their cost of capital.
Very strong companies maintain excellent returns on invested capital, even as they increase invested capital year after year. Others may rationalize their operations, selling off units that generate less ROIC than others. Dumping such operations can shrink a company's earnings, but the valuation on the remaining earnings and capital invested in the business can increase, making the company now worth more.
By looking at a company's financials from an ROIC standpoint, investors account for both the income statement and the balance sheet. The various ratios that an investor considers (leverage, cash conversion cycle elements, margins, asset turnover) are brought together under the unified ROIC model. ROIC also allows an investor to look through the various accounting choices that a company can make to portray earnings. Since most accounting regimes are rich in balance sheet accruals, ROIC is able to identify the real economic return a company generates.
Whatever expenses don't go into net income stay on the balance sheet as part of the company's invested capital. In short, what doesn't get considered in the numerator in ROIC has to be considered in the denominator. We'll discuss that in greater detail next.
For more lessons on return on invested capital, follow the links at the bottom of our introductory article.