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No. of Recommendations: 6
Hi FC,

It took a while for me to get a grasp on ROIC, so I thought I might offer up a more simple look at the formula used in calculating ROIC and the ROIC-WACC spread so that others could have a better understanding of what was going on before reading through Dale Wefflaufer's excellent "A Look at ROIC" here http://www.fool.com/School/roic/roic.htm

Hopefully from reading through the discussions, and the comparisons Pierre offered, we can all see how ROIC helped to show how Medco was a drain on invested capital for Merck. By ridding themselves of the lower margin, capital intensive business of Medco, Merck will be able to turn around their business and offer us a chance to catch a great company at a bargain-basement price.

Return on Invested Capital (ROIC) takes the ratio of ROE and Amortization adjusted ROE to a bit higher level of considering all invested capital as opposed to just equity by also taking into consideration the debt a company keeps on it's balance sheet as well.

After reading through Dale's and others explanations, I tried to reduce the formula to an easier to understand calculation. I thought by making it simpler, we could use it in our company reports.

For ROIC and ROIC-WACC spread, we would have this formula;

ROIC = After tax Operating Earnings / (equity + debt)

WACC = (equity / equity+debt) * discount rate + (debt/equity+debt) * (1-tax rate)


* = times

/ = divide

+ = plus

- = minus

That's it! What you think? :o)

For explantion purposes;

http://www.fool.com/news/foth/2000/foth000927.htm

After tax operating earnings = Net Operating Profits After Taxes (NOPAT)

NOPAT equals:

Start with:
+ Reported Net Income

Add back:
+ Goodwill amortization
+ Non-recurring costs
+ Interest expense
+ Tax paid on investment and interest income (effective tax rate X investment income)

Subtract:
- Investment and interest income
- Tax shield from interest expenses (effective tax rate X interest expense)


-and-

Invested Capital equals:

Start with:
+ Total assets

Subtract:
- Cash, S-T investments and L-T investments (excluding investments in strategic alliances)
- NIBCLs (non-interest-bearing current liabilities)


I just simplified it to equity + liabilities minus investments and NIBCLs -or- equity + debt.

For WACC, it gets a little more complicated. You wanted WACC adressed as a percentage and what I did accomplishes this and simplifies it. Dale's was the most simple explanation I have found, but still not that easy to decipher. You can read his explanation in the "Equity Isn't Free" (part 5) from "A Look at ROIC"

Hope this is not too far off base.

Chin
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No. of Recommendations: 1
Chin

What does WACC stand for?

Judy
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No. of Recommendations: 5
Hi Judy,
Weighted Average Cost of Capital

http://valuation.ibbotson.com/Industry_CCQ/Methodology/ind0033.asp

Regards
Philip

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No. of Recommendations: 9
What a better invitation to add my inputs. Thank you chin : here I go, right in the heart of the subject.

ROIC : Return Of Invested Capital (expressed in %) -and,
WACC : Weigthed Average Cost of Capital. The difference between these two, called
"Spread". When positive, the Spread indicates if company's financial healt is increasing.

How simple is it to derivate those figures for a company is another thing. Chin has provided some information on the matter and a link discussing the advantages of ROIC. A lot of more information exist on this and I guess that we can add a lot more for those interested to dig in any further. The fact is that other indicators exist to provide informations about a company's financial healt, and; from my own experience, it takes a lot of motivation to spend the time in studying, applying and testing those parameters on your own time. Sometimes, there are other tings a lot funnyer to do, but maths can be fun too. Now let's see what the competition can bring to an analyst.

ROE : Retun On Equity, and
ROA : Return On Asset. The difference between these two, called the
"Leverage" indicates if the debt used by the company is producing more cahs than it's cost of interest, whenever positive. Most analyst use this information in combination with other ratios and of course, with the cahs flow production by the company. Simple, isn't it ??

How can the 2 sets of figure compare ?? - The ROIC is reflecting ALL the cahs invested in a company as opposed to ROA which looks at the Asset figure "only". A HUGHES difference since that "ALL the cash" involves more things than what can be shown on the asset sheet, for instance, the real cost of acquisitions from merging that is never reflected in the company's asset, and part of the previous years marketing and R&D. Also, only a fraction of the cash (when present) on the asset sheet is considered necessary with the company's operations. The "excess cash" is not considered in the calculations, nor it's interest.

We may now discuss of a real case : why not Merck & Co. figures ??

>> The figures below are "mine" which means that they are by far "not official", may contain errors and deliberated ajustements to coope with my own interpretation of GAAP misleading informations. However, they are the best that I can provide, given the time invested (more time should mean increased precisions). For example, I don't know if the dividends paid on preferred shares --a debt from an investor's point or view-- should be credited form the Net Income in the case for Merck. Would it be the case, the values below would vary slighty but not enought to justify the time invested to find out! No changes in conclusions, that means.

..................2000.....1999.....1998......1997.....1996

ROIC........30,6......33,4.....40,1......45,8.....37,3
WACC.........8,3.......7,4......7,8.......8,4......8,9
Spread.......22,2.....26,0.....32,3......37,5.....28,3
ROE...........30,2......28.7......20,9......25,8.....23,3
ROA...........25........23,1.....18,3......23,3.....22
Leverage.....5,2.......5,7......2,6.......2,5......1,3
Debt/Asset....41,6......47.......37,8......29........20,2

What the figures tell us :

1- The company is in good financial healt. We need now to find out if it will stay this way.

2- The debt increased substantially during the 1997, 1998 end 1999 exercise and started dropping to a better accepted value during the 2000 exercise.

3- The ROIC and it's Spread started dropping back in 1997. The next results will tell us if the company took measures to stop this "dropping". However a pread of 22 % is not a bad figure if it remains as such.

4- The ROE and ROA are both increasing, back from 1997.

5- The ROE is increasing at a higher peace than the ROA. This is the result of the increase of the debt, and that the additional debt is producing more than it's cost of interest.

The question remains : Why is the ROIC decreasing while the ROA is increasing ??

Althow I cannot answer to this question by myself since I don't know enought about the company; it seems -from Philip's opinon however- that Medco may be involved. Now, is this sufficient to cause so much degradation or the ROIC ? >>I don't know and I cannot answer to this question. But there is a defenitive sign in here (that is, of course, if "I" can trust my own figures) that the financial situation for Merck is degrading. At least, the debt has been increasing for a while.

Certainly the financial community knows about this when you look at the share's price which has stop increasing from the beginning of 1999 except for Jan 2001's peak. And looking at the Free cash flow --net from the stock option exercise influence (as I have posted about this previously)-- it seems to me that stock value may still be a bit too high.

My other questions from all this :

A- Will I wait until this financial situation (ROIC) has stopped deteriorating (althow positive enought so far) before investing, or should I only trust the ROE/ROA + Free cash flow ??

B- Will I be confident enough --after reading all of company's RM criterias documentation posted here-- to convince myself that Merck's ROIC has stopped degreading ??

I gess I'll have to answer those questions by myself; it's my money after all...

Pierre

Oh, I was going to forget!

Q : Does it worth digging into the RIOC and WACC ??

I like to use these values, since I have the figures produced almost automatically. I just have to dig for more precisions when the "Spread" is not clear enought. Also, I don't look further in a company when this value is negative.

However, did it worth going through all that troubble of adding this option to my evaluation tool for producing those values ? >> It's a lot of work for on person, you better love maths!
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No. of Recommendations: 1
Chin et Pierre,

I just wanted to take a moment to thank the two of you for explaining ROIC and WACC. Until you two followed up with the "Simplifying ROIC posts" I had no idea what was going on.

I've printed out everything and will try to digest this evening...but one related question: WACC contains "discount rate" and "tax rate". Where does one obtain the two rates, or is this one of the variables that we need to become better informed?

Barry
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No. of Recommendations: 4
evening...but one related question: WACC contains "discount rate" and "tax rate". Where does one obtain the two rates, or is this one of the variables that we need to become better informed?

Hi Barry,

Your question concerning the evaluation of the WACC if very legitimate and has necessary involved on my part the use of a shortcut in orther to end up with relatively fast results in my evaluation tool. In orther to answer this question, I am using some extracts of the document published by Andrew Chan sometimes ago, for which a revised version is still availiable on the following link :

http://www.geocities.com/andrewychan/index.html

Knowing how to calculate the WACC is just as important as knowing how to calculate ROIC. When these two concepts are combined, they form one of the best valuation tools in securities analysis.

The mechanics of calculating the WACC are controversial and debatable. The reason is that they rely on the Capital Asset Pricing Model (CAPM) to calculate the cost of equity. The CAPM uses beta as a proxy for the market risk of a company. We will see later why it is a hot topic in the academia.

Weighted Average Cost of Capital (WACC)

Definition: The WACC reflects the opportunity cost for debt and equity holders, weighted for their relative contribution to a company's capital structure. It is the minimum economic return a company must generate to compensate its debt and equity security holders for their assumed risk (as per Michael Mauboussin, Plus Ça Change, Plus C'est Pareil, CS First Boston, pp 6.


Formula:


WACC is the sommation of these 2 sections :

1- (Cost of debt) x (1 - Corporate tax rate) x The potion of debt of the firm, which equals : ( (Total debt) / ( (Total debt) + (Total equity) ) )

2- (Cost of equity) x The portion of equity of the firm, which equals :
( (Total equity) / ( (Total debt) + (Total equity) ) )

The " Cost of debt" --or interest rate : The appropriate cost of debt to use is the market value. Using the market value cost of debt is more representative of the cost a company would have to pay if it were to raise debt today. To find the cost of debt, you can look up the yield-to-maturity (YTM) of the company's bonds.

The "Cost of equity" : This is a more complicated element of the equation. While the cost of debt is clearly stated on the income statement as interest expense, the cost of equity doesn't appear anywhere. Nonetheless, equity has a (implied) cost; shareholders must get an appropriate rate of return to compensate for the risk of their investments.

>>> So, here we go again! Academists solve this problem by going through the use of the "beta" which, for many investors such as W. Buffet is a real nonsense. And yet, looking for a beta value for each company under study is not very practical either, since essencially; you'll want to invest in companies thath show "a clear enought Spread between ROIC and WACC". So, we are not going to discuss "beta" here.

>>>Also, and for practical reasons and since Equity is usually a greater componant of the Capital under the WACC, it is therefore recommanded to use the a resonnable "market value of debt". It is important to keep in mind there that the end result is a matter of comparison with ROIC. I personally use the same percentage here as in my DFCF analysis, the latter includind a portion of risk compensation : 9% for Merck.

Pierre
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No. of Recommendations: 1
Thank Phillip

boy, the formula looks complicated - I hope I will be able to master all this.

regards

Judy
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No. of Recommendations: 1
Hey Judy,
I just used one of my precious recs just to encourage you with the WACC math :-)

Besides we can't lose our favourite Aussie

Regards
Philip (a transplanted pommie who used to be a P&O Officer cruising from Sydney)
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No. of Recommendations: 2
What does WACC stand for?

Hi Judy,

And thanks Philip for answering this. Sorry I coudn;t rec your post. Only have 3 more left. Grrrr.

For the simplest terms for what weighted average cost of capital stands for, you might consider what you would expect to return from the company in terms of equity and debt. -or- More simply stated, what return you would expect from another means of alternative investment as opposed to an investment in the company your looking at, like an S$P 500 index fund, or a Total Market index fund. From the article "A Look at ROIC" they adjusted for risk for the first part of the equation (return expected from equity). Since the company carried a lot of debt, the felt like the needed to expect a 20% higher return than what they could have realized over a long-term (50 years) investment in the S$P 500 to adjust for the extra risk from owning a company with the extra debt (dead weight) to carry. So one plus the 20% would equal 1.20*11%, -or- 1.2*11=13.2 (13.2%).

In my simple way of thinking, what I saw here was a discount rate such as used in calculating the IV (intrinsic value) for a company. I don't think you've had much experience with this yet, have you?

Check out LeBean's here www.valuationconcepts.com

You might want to read through his letters too.

Have any questions, just ask.

Chin

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No. of Recommendations: 1
thank you Phillip

you want be loosing me - who else can answer all my questions and put up with the confusing posts - which is what happened with the bank analysis - it still doesn't tell me a story. but then i did the financial seminar and now i am trying to analyse a food company using those figures (my spreadsheet is bcming more controllable) and I am now up to calculating ROIC on it so the questions I am sure will keep coming.

thanks for the encouragement (i have one more rec for today - I didn't realise how often I used them)

Judy
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No. of Recommendations: 0
I haven't had any experience with intrinsic valuation using DCF - I am sort of avoiding it at the moment; I use EV/ebit and PE trends but i haven't done discounted rate yet - it is something that will have to be done soon.

well off to working out ROIC for afood company - the company whose financials I am trying to decipher this week bcs my broker is recommending this as a buy - he reckons it will be taken over by the parent company but the finanials are really worrying me - so I don't think at the moment at least it will enter my share portfolio - see what happens after I calculate ROIC.

judy
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No. of Recommendations: 3
>>> So, here we go again! Academists solve this problem by going through the use of the "beta" which, for many investors such as W. Buffet is a real nonsense. And yet, looking for a beta value for each company under study is not very practical either, since essencially; you'll want to invest in companies thath show "a clear enought Spread between ROIC and WACC". So, we are not going to discuss "beta" here.

>>>Also, and for practical reasons and since Equity is usually a greater componant of the Capital under the WACC, it is therefore recommanded to use the a resonnable "market value of debt". It is important to keep in mind there that the end result is a matter of comparison with ROIC. I personally use the same percentage here as in my DFCF analysis, the latter includind a portion of risk compensation : 9% for Merck.


Hi Pierre,

I agree. BETA will give some wildly varied numbers that don;t always work, especially in the beginning of a bear market for cyclicals, or those we favor, the ones that are out-of-favor. I'm glad to see agree on using the discount rate. That makes the most sense to me.

In answer to one of your questions in a previous post, I think ROIC definitely has a place in our RM criteria. For the FC, this may be a time-proven matter. We may have to look at it for a while with the companies we are looking at (as you mentioned) before we all can decide on the valididty of ROIC.

I however may already be convinced. I have been looking through the stats offered in a book "What Works on Wall Street" by James P. O'Shaughnessy. Probably not one of the highest reccomended readings, but it does offer some statistics about different strategies and how they are proven over the long-term (1951-1996). From what I have seen so far, large cap stocks bought while selling at low P/Es using the top 50 for each year showed tremendous growth improvements (not a huge revelation, Huh?).

We don't have the database (compustat was used in the book) to study how these companies would have done with ROIC, but I feel with the questionable earnings we might be looking at in today's company reports, this has it's relevance. It's not an all-in-one tool for measuring the value of a company. (Off balance sheet debt wouldn't show up in this) It does have it's place with the other ratios for RMs we use though. It would just be a compliment to the quantitative analysis portion of the criteria (as you have already stated), but one worth the extra work involved. "Anything worth doing is worth doing well."

JMHO,

Chin

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No. of Recommendations: 0
I haven't had any experience with intrinsic valuation using DCF - I am sort of avoiding it at the moment; I use EV/ebit and PE trends but i haven't done discounted rate yet - it is something that will have to be done soon.

Judy,

Just for a short cut, you could use 11%. Gotta go now. My time to carry the baton. (Tag-team homework helpers :o)

Chin

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Hi chin

what do you mean I could use 11%?

Judy
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No. of Recommendations: 3
what do you mean I could use 11%?

Hi Judy,

What I meant was instead of trying to figure out a discount rate to use for the equity portion of the WACC, you could just simply use 11% across the board for all companies. This might be low for riskier companies and high for lower risk companies, but the reasonable rate of return you would expect for any company would be the 50 year average of 11% you could get from simply investing in an S&P 500 index fund or a Total Market index fund. It would just simply be a standard that wouldn't need a lot of thought proccessing, research, or experience in adjusting for the discount rate portion of my simpler formula for WACC, and if the spread between ROICC and WACC is low enough that this small amount of difference would be warranted, that in itself would throw up a red flag on the company you are looking at.

Prety much, the ROIC-WACC spread just gives you a vague idea of how well the company is growing their invested capital. In fact, in the spirit of "Using calipers to measure what you will cut with an ax" LeBean has mentioned, you might would be comfortable just seeing that the company could improve on the 11% expected return as opposed to WACC. Just simply sbtract in your mind the 11% from the ROIC.

We might eventually set a standard of something like an ROIC no less than 15%, or something like that.

Hope this explained it well enough. If not feel free to question where I might have muddied the waters.

Chin
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No. of Recommendations: 1
Hi Chin

I was thinking about that - I thought that I would use 8% as WACC bcs that is how much it costs to borrow money here - but maybe 6% bcs that is the most I could get from my money at the moment if I put it in a term deposit account and I would want any compnay that I own to make more than if I put it in the bank.

Wesfarmers, one of the best companies here in oz, is a conglomerate that does a lot of takeovers. They look for ROIC in a takeover targer of more than 18% and return on equity after tax of 16%.

so I was thinking why reinvent the wheel and do what the experts do, but I have to be able to calculate those ratios first off. So that is what I'm going to do now.

judy
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No. of Recommendations: 1
Chin

I think i'm Ok with NOPAT. but I'm getting confused with invested capital.I can find equity and liability (and I also think that cash should be left in, though andrew deletes it)

equity - not a problem
total liabilities - not a problem
investments ? do you subtract investments in other entities
NIBCL ? does that include payables, current tax liabilites and provisions.

judy
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No. of Recommendations: 1
another question - does capital reserves mean cash? I think it does but this is such a funny company and I am getting more and more confused as I read the financial statments.

judy
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No. of Recommendations: 3
I think i'm Ok with NOPAT. but I'm getting confused with invested capital.I can find equity and liability (and I also think that cash should be left in, though andrew deletes it)

equity - not a problem
total liabilities - not a problem
investments ? do you subtract investments in other entities
NIBCL ? does that include payables, current tax liabilites and provisions.


Hi Judy,

Unless someone has an objection, let's just simplify this a little. Instead of starting with total assets and reducing that side of the balance sheet (assets-liabilities = equity), lets just start with equity and add back all debt (equity + liabilities = assets). This should take care of all the complicated adjustments.

Investments and NIBCLs (payables don't require interest to be paid)don't add to the cost of cash-to-cash return, and tax liabilities are more an accounting entry(also no interest paid if paid on time).

In cash-to-cash, we are looking at the amount of cash it requires to accomplish the amount of cash returned. Where the company would find this if they didn't have it on hand (cash on the balance sheet is a retained amount from cash returned), would be from issuing shares or taking on debt.

If we were to consider cash, I would subtract it, because it would reduce the likelihood that the company would have to take on more debt.

We don't consider investment income, so we couldn;t consider investments in the denominator.

There is no cash amount set aside to take care of deffered taxes, because (as best as I understand it) deffered taxes are taxes that may never need to be paid unless the company sold an asset such that contained something such as goodwill that they would get more for than they paid, and haven't reduced the amount by amortization. (this is discussed further in the "A Look at ROIC")

Current tax liabilities would be paid through cash. If these and payables were larger than cash, we might have a problem, but for this ratio, I think it best we don't consider this.

For a simple little exercise, we could use the TMF balance sheet for a company and look at it. If you'd like, choose one, and we'll go through it.

Anyone else have a different view of this?

Chin

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No. of Recommendations: 4
May be a little late to do any good, but if anyone's still reading this far, I think there is a typo in Chin's excellent post starting off this thread.

Chin's original WACC formula:
WACC = (equity / equity+debt) * discount rate + (debt/equity+debt) * (1-tax rate)

and the debt part of it, from a few posts later, which I believe is correct:

1- (Cost of debt) x (1 - Corporate tax rate) x The potion of debt of the firm, which equals : ( (Total debt) / ( (Total debt) + (Total equity) ) )


My explanation, as I understand it:
The cost of the debt portion of the capital is the size of the debt times the interest that debt costs, but it's actually less, by
(1 - tax rate)
because the interest expense is tax deductible.
The factor (total debt / debt + equity) is the weighting factor which determines how much of the Weighted Average Cost of Capital is due to the debt part, and how much is due to the equity part.

So, what I'm saying is that the original formula in the first post was, I think, meant to be:
WACC = (equity / equity+debt) * discount rate +
(debt/equity+debt) * (1-tax rate) * interest rate

i.e., ths interest rate, which is the cost of the debt, was left out.

Of course, I might be just missing it, this stuff is complicated. Maybe Chin will get back by here to confirm what I'm saying, or to straighten out my straightening out.

== dj


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No. of Recommendations: 5
Chin

this is what I have done - does it make sense - have I done it correctly?

2001 2000
income statement
operating revenue 1607469 1556174
cost of sales 1084440 1028268
selling and marketing expenses 146697 150379
general and administrative expnses 341807 325998
R&D 0 0
other operating expnses 12326 23473
depreciation (note 2c) included in other expenses
amoritisation (note2c) 40 42

operating income before taxes = NOPBT (calculation for ROIC)
22239 28098
operating profit after taxes (company tax rate 35% in 2001) = NOPAT 14455.35 18263.7

balance sheet
total current assets 445865 415630
non-interest bearing liabilities
payables 147640 135921
current tax liabilities 6231 10619
cash 30448 41379
investments (excluding investments in strategic alliances
0 0

invested capital 261546 227711

ROIC 5.53% 8.02%

If I have the calculations right (I don't think for this company I have to work out WACC) - return on money from the bank in this country is approx 4% this company is only earning a little better - so I wouldn't touch this company - it seems to be doing quite badly.


Judy






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Hi dj,

I guess you are wright. Althow this question is adressed to Chin, it may be answer with the informaiton included in one of my previous post above. Here is an extract where I have bloded the parameter that you are looking for :

Formula:


WACC is the sommation of these 2 sections :

1- (Cost of debt) x (1 - Corporate tax rate) x The potion of debt of the firm, which equals : ( (Total debt) / ( (Total debt) + (Total equity) ) )

2- (Cost of equity) x The portion of equity of the firm, which equals :
( (Total equity) / ( (Total debt) + (Total equity) ) )



Pierre
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No. of Recommendations: 6
Of course, I might be just missing it, this stuff is complicated. Maybe Chin will get back by here to confirm what I'm saying, or to straighten out my straightening out.

Hi dj,

You and Pierre are absoluteley correct. What I have in my document is;

ROIC = After tax Operating Earnings / (equity + debt)

WACC = (equity / equity+debt) * discount rate + (debt/equity+debt) * (1-tax rate*cost of debt)

but I like your idea of stating cost of debt as the interest rate, so I am changing it. Stating it as cost of debt could confuse further. Instead of cost of debt, I'll replace it with "interest rate" . That makes much more sense.

What WACC is supposed to represent is the return that you would expect from the company to off-set the ROIC. In my simple way of thinking, the discsount rate would serve better than the complicated formula for WACC. The discount rate they used in the example was 13.2% (in the equity factor) and still the WACC came out to 9.7%. This is based on the EVA formulas for evaluating a company, and I find the use of BETA for determining the discount rates to be way off base, amoung other things.

What would you or others think of just simply stating the WACC as the discount rate you would apply to the company, or the 11% you might expect for the long term for the S&P 500 as an alternative more secure investment.

I have already taken the formula to measures that some might see it as distorting the accuracy of the equation, but I feel by simplifying it, we could make it more usefull.

The Weighted Average Cost of Capital (WACC), in it's simplest terms is supposed to be what you might expect to receive from an alternative investment in an investment in something like the S&P 500 index fund, or a portfolio that you felt less risky. So can I take this one step further without drawing to much ire from those who might feel I'm chopping the equations apart. I would suggest we just simply use this formula;

ROIC - WACC spread;

ROIC = After tax Operating Earnings / (equity + debt)

WACC = Discount rate

To me, this is what the ROIC - WACC spread is supposed to be all about. You want to see that the company is making good use of invested capital. That's pretty much it.

What you think? (you too Pierre)

Chin

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If I have the calculations right (I don't think for this company I have to work out WACC) - return on money from the bank in this country is approx 4% this company is only earning a little better - so I wouldn't touch this company - it seems to be doing quite badly.

Hi Judy,

Excellent work! Could I ask you to do one more thing. For invested capital, could you add equity to debt (both long-term and short-term) and see what you come out with. You're right, it doesn't look like this company is making good use of invested capital. I wouldn't mind going a little deeper into this to see how it works, but if after dividing NOPAT by equity+debt the results are still around the same, it might pay to look at a different company.

Thanks for your interest in this. I don't think ROIC is going to work for banks, but we can take a look-see after we get the basics down.

Chin
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No. of Recommendations: 3
Hi Chin and dj,

but I like your idea of stating cost of debt as the interest rate, so I am changing it. Stating it as cost of debt could confuse further. Instead of cost of debt, I'll replace it with "interest rate" . That makes much more sense.

IMO, the "cost of debt" may carry a different signification than "interest rate". The latter has to do with the "actual cost" to borrow money. The "Cost of debt" that we should be looking for here is the cost that was contracted by the company for borrowing it's overall debt, and of course; the rates obtained may be different for each contract (different dates, different conditions). The "Cost of debt" will be the sommation of all interest paid on loans, credit margin, dividend on preferred shares, debentures, etc. in a particular year; divided by the total --or maybe average, to be more precise-- debt during that year. Some organizations may have a very low "Cost of debt" while the current rate may be a lot higher (the present situation about interest rates being only temporary IMO). A short cut to find this "Cost of debt" would be to use the rate obtained for the most recent loan, probably the worst case.


I can see that you (Chin) are looking for simplification, and I think that you are quite justify to do so : life is complicated enought!

But, to say :

WACC = Discount rate means that the company has no debt or that you give the company no consideration for negociating good rates for it's debt... Humm, Of course, if you end up with a positive spread by using WACC =11% (for example), then you have no problem.

and,

ROIC = After tax Operating Earnings / (equity + debt) implies that you are saying :
"After tax Operating Earnings" = NOPAT; and,
"(equity + debt)" = Invested capital

By simplifying the formulae this way, you will end-up with an approximative answer. Again, the results may be sufficient , if the spread is large enought (for an investment decision), or; just OK for a first analysis, prior to a deeper investigation.

However, I prefer to stick around whith the official version of the ROIC, or; as closed to it as I could get. As I said previously, there are several estimations required to evaluate the NOPAT and the Invested (operating) capital. Simplifying the formulae in addition to those estimations IMO would just add more distortion (and maybe a lot more distortion) to your results.

Adapting the formulaes to your own needs may means that you know what you are doing and when to investigate further. And, just as no two analyst would come out with the same IV for a given company, I think that the same applies for evaluating the ROIC!

Those are my thoughts

Pierre
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but if after dividing NOPAT by equity+debt the results are still around the same

Hi chin

I will do that later on in the day. I am now trying to look at Brambles - isn't it funny - I enter the figures in the first company and think I have it right and understand it and then I try to enter the figures in a second company and have to start from scratch.

It will be interesting to try this with the banks, but yes I agree with you first we and definietely me have to understand this properly.

Judy

by the way I have put an order in for the shares, at a price below or just at NTA, in the company - I rang my broker and said to him what I had found and he said yes he knows and agrees with all of it. He said that the company is bringing things around and that the chairman has acknowledged everything in his address. The company has no debt to speak of and if it doesn't improve will be taken over by its british parent, which owns 80% of the company. If it is taken over then they will pay 1.5x NTA, if not then I have bought the company on the turn around - so either way I should be OK. I found that by doing the financials I have not gone in blind and can be comfortable with what I have done. I have also looked into what the company makes etc. and am fine with that - it is one of the leading food producers in this country and owns many of the well known brands. It has been in the business over 40 years (though that doesn't mean much in todays world).
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WACC = Discount rate means that the company has no debt or that you give the company no consideration for negociating good rates for it's debt... Humm, Of course, if you end up with a positive spread by using WACC =11% (for example), then you have no problem.

and,

ROIC = After tax Operating Earnings / (equity + debt) implies that you are saying :
"After tax Operating Earnings" = NOPAT; and,
"(equity + debt)" = Invested capital

By simplifying the formulae this way, you will end-up with an approximative answer. Again, the results may be sufficient , if the spread is large enought (for an investment decision), or; just OK for a first analysis, prior to a deeper investigation.


Hi Pierre,

I pretty much agree with what you are saying here. I do feel comfortable with using the same discount rate we would apply to a company in a DCF ro Intrinsic Value calculation. By doing so, and not considering the interest rate differences in cost of capital, we would come out with a higher (more conservative) number for WACC, and adjust it more to fit the company or industry we're looking at.

When using ROIC = After Tax Operating Earnings/(equity+debt) NOPAT is a good start, and equity+debt brings this down to a more understandable equation.

As with anything else we look at, we always need to go deeper.

I wouldn't mind taking ROIC to the umpteenth degree, if your willing. Could we take a company and study each adjustment one-at-a-time. Things like depreciation, amortization, and stock options would require that you really sunk your teeth into the notes to see what would or would not deserve an adjustment. Maybe we could start with operating earnings since this is one place we really need to clear the grey area in.

What you think?

Chin
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Hi Judy,

:o)

Imagine that smily face with a little red tint. What is NTA?

Chin
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Hi Chinwhisker,

I would imagine that NTA is Net Tangible Assets.

Lost
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I wouldn't mind taking ROIC to the umpteenth degree, if your willing. Could we take a company and study each adjustment one-at-a-time. Things like depreciation, amortization, and stock options would require that you really sunk your teeth into the notes to see what would or would not deserve an adjustment. Maybe we could start with operating earnings since this is one place we really need to clear the grey area in.

Hi Chin,

Well I think that we could both learn from this experience while finding another place where to invest (or not). Maybe other member of FC will be ready to participate also.

I so happens that I am presently reading a french version of Jack Welch's book and I would be very interested into an analysis of GE (5 years of data). What you think?

Pierre

PS : By the way, unless you had access to the detailed figures of an enterprise, such as a CFO would; there is no way you could be taking ROIC to the umpteenth degree. You can onnly get a "sound" outsider approximation.
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Well,

...Come to think of it, GE may be a little rough to start with!!

Pierre
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NTA=net tangible assets

judy
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First let me thank Lost and Judy for clueing me in on Net Tangible Assets. Should've thought of this, but guess I'm suffering through a bit of information overload from all the accounting finagling articles. :o)

I so happens that I am presently reading a french version of Jack Welch's book and I would be very interested into an analysis of GE (5 years of data). What you think?

Pierre,

GE would be totally new to me. I have never considered an investment in this industry, so the opportunity to look at it does interest me.

Where would you like to start?

PS : By the way, unless you had access to the detailed figures of an enterprise, such as a CFO would; there is no way you could be taking ROIC to the umpteenth degree. You can onnly get a "sound" outsider approximation.

Are you saying Enron's CFO did know what was going on? :o)

A "sound" outsider approximation might be a bit above the umpteenth degree for me.

I don't remember the 30 page report done on ROIC, but I couldn't get it to come up, possibly due to the version of Abode I use. Keep in mind, I'm starting from scratch here, but will put out by best effort to dig through and find the real numbers to use.

Well,

...Come to think of it, GE may be a little rough to start with!!


Either way you want to go. If not GE, and since you have already done Merck, what about Cake?

I'm ready to go in any direction you choose.

Lead the way,

Chin
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I wouldn't mind going a little deeper into this to see how it works, but if after dividing NOPAT by equity+debt the results are still around the same, it might pay to look at a different company.


Hi Chin

OK the results are as follows:

2001 2000
ROIC 5.53% 8.02%
NOPAT/equity + debt 1.60% 2.09%

so not doing too well. though I really should look at the financials of the past 5-10 years.

I spoke to my broker - I don't think I will be buying this share - it has just skyrocketed and is way above net tangible assets - that makes it too expensive for me (my broker valued the NTA at $6.00) - it is now close to that price , someone from one of the big brokerages was buying it yesterday.

something else will come along - it looks like the earning announcements in this present season aren't doing too well and we are seeing a backlash from the enron and HIH (australia) collapses - all linked with shonky financials.

judy
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I spoke to my broker - I don't think I will be buying this share - it has just skyrocketed and is way above net tangible assets - that makes it too expensive for me (my broker valued the NTA at $6.00) - it is now close to that price , someone from one of the big brokerages was buying it yesterday.

Hi Judy,

Did you see "Forrest Gump", "It Happens". :o)

something else will come along - it looks like the earning announcements in this present season aren't doing too well and we are seeing a backlash from the enron and HIH (australia) collapses - all linked with shonky financials.

Might be a good time to wait on the 10Ks, or 8Ks to check the validity of earnings and results of the "fear" that is spreading through the corporate offices of overstating earnings or playing accounting games on the balance sheets.

And you're right. Unless you have the right buying opportunity, best to wait.

Chin



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Hi Judy,

Just read your post #7156 on Enron and HIH Re: Simplifying ROIC.

I love your word shonky used with financials. I've never seen shonky used before. I guess I'm just too sheltered to see these new words.

Really enjoy reading your and Chin's posts.

Thanks for the new word...shonky.

Regards Jack ♦
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Hi Chin,

GE is a real tough one. This is due to the structure of the company. GE consolidated includes GE manufacturing & services buziness; and GECS (GE Capital Service) organization, for their banking activities. In orther to get a "clear" (if such a word exist in investing) or adequate picture of GE Corp.'s financials, you also have to perform your study on both componants as well... Meanning : We'll never finish with our project. I have already spent the whole day on GE Corp. financials and I am putting my work aside for a while. There are Impressive figures in GE Corp. : revenu = $130 billions, Asset = $436 billions!!

It may be more practical to use Cake, since Tom has providied the best incentive ever (thanks Tom, my printed copy will be of use).

I don't remember the 30 page report done on ROIC, but I couldn't get it to come up, possibly due to the version of Abode I use.

I don't know how I could be of any help with this. I am using Acrobat V4. I think that the time spent to upgrade your verion will be well worthed. In addition; you get to use the "copy paste" option that may be handy sometimes.

Are you saying Enron's CFO did know what was going on? :o) Maybe, and I'll believe ALL what he will eventually say on this.

Bye for now,

Pierre
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Hi Jack

I suppose 'shonky' is Australian slang - the nearest translation would be 'suspect'

Glad that you enjoy Chin's and my posts - you are welcome to join us anytime

Judy
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