For those who have followed my analysis, you may realise that I always compare the company’s return on invested capital (ROIC) with the weighted average cost of capital (WACC).
Do you know why I do that?
Before I explain why, let me briefly tell you what WACC is.
WACC is a metric that assesses the overall cost of financing a company's operations and investments.
A company is financed by different sources of capital, such as debt (loans or bonds) and equity (shares or ownership). Each source comes with a cost, meaning an expense is associated with using that particular type of funding.
WACC considers the proportion or weight of each funding source and calculates the average cost based on those weights. In other words, WACC considers both the cost and the relative importance of each funding source.
To calculate WACC, you need to know the cost of debt, the cost of equity, and the weights of debt and equity in the company's capital structure.
Do I calculate each company’s WACC myself?
No. It is a complex calculation that requires a lot of time, so I obtain the figure from online sources.
Now back to the main question: why do I compare the company’s ROIC with its WACC?
That is because, if the WACC is higher than the company’s ROIC, it shows that the company is not generating sufficient returns to cover the cost of its capital.
Investors use the WACC as a benchmark to evaluate the efficiency of a company's capital allocation and management of its funding sources.
By factoring in debt and equity financing costs along with their proportions in the capital structure, WACC helps determine the minimum required rate of return to satisfy all capital providers.
A lower WACC is generally seen as favourable, but the appropriate WACC is subjective. As such, no fixed value can be considered “good” for a company. It depends on its industry, capital structure, and risk level.
I also know of value investors who use WACC as part of their valuation. They use it as the discount rate to calculate the present value of the company, thereby estimating its intrinsic value.
Some of you might start wondering if the WACC is the same as the required rate of return (RRR).
Well, while the two measures represent the expected returns for investors, they differ in several aspects.
First, the WACC calculates the average return a company must provide to its investors based on its capital structure. On the other hand, the RRR is the minimum return investors demand for a specific project or security.
Next, the WACC considers the different weights of debt and equity in the company's capital structure to determine the overall cost of capital. However, the RRR focuses only on project-specific risks and opportunities.
So in short, WACC measures overall capital cost, while RRR assesses investment viability.
As I mentioned earlier, I use online sources for the ratio because it is complex to calculate. But the biggest drawback is not its difficulty in calculating. It is the assumption that investors make.
It assumes that the company's capital structure will remain unchanged, which may not always be true. It is also important to note that companies can increase debt to lower the WACC, which can lead to complications.
I hope this helps you understand what WACC is, and how and why I use it against ROIC. But remember, it is important not to rely on just one ratio alone when making investment decisions.
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