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I want to master the ability to calculate on my own, at will, the spread between a company's ROIC and its WACC. Unforunatley, I'm struggling to locate the data I need to complete the necessary calculation:

ROIC =((1 - t)(EBIT)) / ((A - cash) - (ST and LT investment) - (non-interest-bearing current liabilities))

Specifically, how do I determine a companies ST and LT debt and its weighted average cost of capital. Any help will be greatly appreciated.

Thanks you.
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fbeckner,

You can find the amount of long term and short term debt a company holds by looking at the company's balance sheet. You can find the company's balance sheet by looking through the latest 10Q or 10K, whichever is most recent.

While you can look for these numbers on sites like Morningstar or Yahoo Finance, I'd suggest going to the source documents. You can look these documents up at the SEC's web site at www.sec.gov. When you get to the site go down the "Filings and Forms" section and click on "Search for Company Filings."

As far as WACC goes, I personally don't always use it in valuations and typically just use a cost of capital of 10-12%. However, I do think it's important to at least know what WACC is and how to compute it so you can make your own decision. Investopedia.com has a nice page explaining what WACC is and how to compute it:

http://www.investopedia.com/terms/w/wacc.asp

Basically WACC weights the market value of the equity and the market value of the debt by the percentage that each makes up the total market value of the firm. It then takes these weighted values and multiplies them by the cost of equity and the cost of debt, respectively. Since interest payments on debt receive a tax deduction, the cost of debt is reduced by multiplying the cost of debt by (1 - tax rate). After this modification, the cost of debt and cost of equity are added together to get to the cost of capital.

You might wonder though where the cost of debt and cost of equity come from. :) Cost of debt is fairly straightforward. You can look at what interest rate the company is paying on it's debt, which is disclosed in the 10K's and 10Q's. Cost of equity is trickier. Typically here I would just use 10-12%. Textbooks would tell you to use the CAPM and use beta and the risk free rate to calculate the cost of equity, but many people, myself included, don't think beta (historical volatility of the stock with respect to the index) is necessarily a useful tool for determining what the stock will do with respect to the index in the future.

Might want to double check your ROIC formula. You have:
ROIC =((1 - t)(EBIT)) / ((A - cash) - (ST and LT investment) - (non-interest-bearing current liabilities))

I would use:
ROIC =((1 - t)(EBIT)) / (Total Assets - non-interest-bearing current liabilities)

Cash is an asset invested in the business. You wouldn't want to remove it from the denominator. Same with long and short term debt. The only thing you typically remove is non interest bearing liabilities like account payable or deferred income tax liabilities, as these are not assets invested in the firm.

In practice I generally look for companies that have a return on capital in the low teens or higher or for companies that may currently have a low return on capital but with some fixing could turn themselves around.

Mike
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Mike,

Thanks very much for responding. Your comments have been extremely helpful to me!

Using SEC filings I have calculated the 3rd quarter 2008 ROIC for Atheros Communications, Inc. ATHR as follows:

ROIC = (1-t)(net revenue - operating expenses)/(Total assets - NIBCL)
= (1-.093)(374100-157456)/(615469-106384)
= (.907)(189644)/509084
= 172007/509084
= 33.78%

I obtained "t" from Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations, Provision for income taxes which states the effective tax rate as 9.3%.

Can you confirm my calculation. The 1st quarter 2007 ROIC for Atheros was 13.81 but the effective tax rate at that time was over 20%. If my calculation is correct should I expect year end filings to report a more modest ROIC for Atheros... a ROIC of 33.78 seems high to me but hey, what do I know?

Again, thanks for the guidance and on to the the WACC.

By the way, I see that the WACC is calculated using using TC (corporate tax rate). Is this the same as the effective tax rate I used in my ROIC calculations?

FB
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FB,

Be very carefule with that tax rate! A 9.3% tax rate is very likely not sustainable. Yes, that was the tax rate in 2007, but the tax rate was 29.6% in 2006. Usually corporate tax rates are somewhere between 28%-40%, depending on what state they are domiciled in and how much business is done overseas in different tax rate countries.

For things like tax rate I always like to use smoothed 3-5 year averages. That helps get rid of one-time things that can cause very different rates year to year. Looking at ATHR's numbers, their tax rate has been all over the place the last few years. Find out why. After that, try to establish a best guess tax rate going forward into the forseeable future. If you are much below 30% you are probably being much too optimistic.

Remember that individual financial statements are just snapshots in time. After you have read the most recent statements, look at the last few year's of data (morningstar is great for this) to get an idea for any abberations that make the current year financials unrepresentative of what the company will accomplish in the future.



Mike
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Regarding your question about the tax rate to use for both ROIC and WACC, I would make sure to use the same tax rate for both so you are comparing apples to apples. Again, for Atheros, the trick will be in finding a good tax rate going forward.

Also, take a look at Atheros' margins. Over the last three years both gross margin and operating margin have been steadily climbing, which would have the effect of increasing return on capital, assuming the capital base remained about the same. Find out why the margins have increased so much so quickly and if that growth is sustainable (it's probably not).

And that's the real trick. In a few days you'll be a master at knowing what all the inputs to ROIC and WACC are and where to find them, but the real devil that resides in the details is that all those inputs have to be examined for their sustainability and reliability going forward.

I find that these boards are a great resource for bouncing your ideas off of other people. Post to the Atheros-specific message board and see what other people following the stock think about your ideas and calculations. Third party criticism like that is SO valuable, expecially when you are just starting out.

Mike
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Mike

It seems I still haven't got it.

Looking at the 2006 annual filing for Guess GES for the numerator I see an effective tax rate at page 35 stated as 37.1%. Net revenue is 1,185,184 and operating expenses 326,356 for an EBIT of 858,828.

For the denominator Total Assets equal 836,925 and NIBCL 289,896.

So, ROIC = ((1-.371)(1,185,184-326,356))/(836925-289896)
= ((.629)(858,828))/547,029
= 540,202/547,029
= .9875

TMF's Investor's Guide (Stocks 2009) gives GES's ROIC for FY 2006 (ending on 12/31/2006) as 18% so I am off by about 80%.

Can you tell me where I have gone wrong?

Thank you.
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Hi again Mike.

I sent you a message this morning before I realized you had responded to an earlier one I sent yesterday.

Sorry for the confusion.

I will now study your most recent comments and again thank you very, very much for taking the time to help me.

Sincerely,

FB
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fbeckner,

Looks like you have the tax rate, revenue, and total assets correct, but your EBIT figure is off. You took revenue and subtracted operating expenses. When you did this you missed subtracting cost of goods sold ($665,805), so your numerator is too large.

For GES, cost of goods sold would be the cost to make and ship all of the clothes. Operating expenses are expenses more like advertising, head office expenses, executive salaries, and other expenses not tied directly to production of the product. When you subtracted just operating expenses you basically created a company that could produce and ship its products for free and just needed to pay advertising, etc. expenses. Pretty cool if you could swing it! :)

What I would recommend is to start with operating revenue (already has cost of goods sold and operating espenses subtracted out) and multiply that by the tax rate, so you'd get this for the numerator:

(in thousands)
GES's operating revenue: $195,997 * ( 1 - 0.37) = $123,478

Your denominator looks pretty good. I get $836,925 for total assets just like you. For non-interest-bearing liabilities I get $249,539, adding together accounts payable and accrued expenses, which is pretty close to what you got. So that gives me this for the denominator:

$836,925 - $249,539 = $587,386.

Dividing, I get:
$123,478/$587,386 = 21% ROIC

So we're much closer now. A few recommendations:

1. Everyone will calculate this a bit differently. For example, some services may calculate the denominator as average assets instead of the assets at the end of the year, averaging the current year end assets with the previous year end assets. So unless the service lays out exactly how they calculate their figures, trying to get within 1% or so of their number will be tricky and probably not too useful. If you are off by 5% or more it is definitely worth checking to see what you (likely) did wrong.

2. Play around a bit with the numbers. We used a tax rate of 37%, which was their tax rate in 2006. But their 2008 tax rate was almost 40%. Just plugging 40% into the above calculations lowers ROIC by 1% to 20%.

3. If you are just starting out, calculate ROIC (and margins) for some of the best, worst, and average companies in the world. Right now, a ROIC of 21% may not have much meaning to you since it's just a number. Calculate ROIC for Coke and Microsoft, some of the highest ROIC businesses out there. Calculate ROIC for GM (one of the lowest). Start getting a feeling for what the upper and lowers ends of ROIC would be. That way, if you calculate ROIC for a company and it's twice as good as Microsoft's, you'll have an immediate idea that you probably did something wrong.

4. ROIC typically sits somewhere between ROA and ROE, so this is another good way to check your figures. ROIC is typically less then ROA since you are removing NIBL's from the denominator. ROIC is typically larger than ROE since, even though you have subtracted NIBL's, the remaining assets are typically still larger than just the equity portion of the company.


Mike
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I can't help with the ROIC calculation (yet), but I think I can help you simplify the WACC Calculation.

You can use thatswacc.com to automatically calculate the Weighted Average Cost of Capital for any publicly traded firm. (Disclaimer: I maintain the thatswacc.com site, so apologies for shilling here, but I think it addresses your specific need). You type in the ticker symbol for the company you are interested in, and WACC is calculated automatically.

You can see more details on the site, but here is the general process thatswacc.com uses to calculate WACC:

After you type in the ticker symbol, the site pulls back and displays 3 years (if available) of balance sheet (bs) and income statement (is) data for elements relevant to the WACC. It also finds an estimate of Beta for the stock.

recall that WACC =(D/V)*(1-Tc)(rD) + (E/V)(rE). The 'component' values that make up the WACC are calculated as follows:

Rd (cost of debt) = Interest Payments/(Short Term Debt + Long term debt)
where...
* Get Interest payments (from IS)
* Get Long Term and Short Term Debt (from BS)

Tc (Corporate Tax Rate) = 3 yr average of (Taxes Paid/Net Income Before Tax)
where...
* Taxes Paid (from IS)
* Net Income before Taxes (from IS)

rE (cost of Equity) = calculated using the Beta of the firm's stock and the CAPM (capital asset pricing model) equation.

D = total short term + long term debt in balance sheet
E = Total firm intraday market cap
V = D + E

The site calculates WACC and also shows the calculated values for all the 'component' variables (such as Tc, rD, rE, etc). You can then change any of the input variables you deem necessary (for example, the 3-year average tax rate at Borders Group (BGI) calculates to around -48%, so I always 'override' that with 28%, assuming the -48% isn't sustainable.

I hope the site is useful in your research (or simply that the steps above assist you in manually calculating WACC).

Good luck!

Mitch
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