ROIC > WACC on behalf of companies to raise debt is advantageous
Many people in the market will mention ROE and ROA because of their easy calculation method. In addition, Buffett mentioned the concept of ROE , which makes this concept popular in the streets. ROE is greater than ROA, which means that it is beneficial to borrow money, but these two data can be changed arbitrarily through accounting games. Not to mention that some companies in the United States that buy too many treasury stocks have caused shareholders' equity to become negative. At this moment, ROE is no longer useful. It is a better indicator to use the size of ROIC and WACC to measure whether a company's debt is beneficial , because it is more difficult to make changes through accounting, and it will not be difficult to evaluate because the purchase of treasury stocks becomes a negative number.
So, what is ROIC ?
ROIC = Earnings before interest and taxes ( EBIT ) × ( 1- tax rate) ÷ invested capital
Invested capital = shareholders' equity + interest-bearing liabilities + unpaid dividends payable + shareholder's interest-free borrowings
Interest-bearing liabilities: short-term loans, long-term loans, interest payable, etc.
It seems that the formula is complicated. In fact , the concept of ROIC is very simple. It refers to the relative relationship that an enterprise can create profits by investing capital . The author divides the enterprise into three types to explain it.
1. Working Capital Growth < Earnings Growth
2. Working capital growth = earnings growth
3. Working capital growth > Earnings growth
1. Working Capital Growth < Earnings Growth
Let’s start with an analysis of Buffett ’s idea of buying See’s : " We bought See’s for US$ 25 million . At that time, sales were US$ 30 million, and net profit before tax was less than US$ 5 million. The working capital required It is 8 million dollars. A small amount of seasonal debt needs to be repaid for several months each year. As a result, the company received 60% of its pre-tax net profit on the capital invested . There are two factors that help the company's required working capital to be minimized. First of all, the product is sold in cash, so there is no need for accounts receivable.
Second, the production and sales cycle is short, which can reduce inventory to a minimum.
Last year See's sales of 3. 83 billion US dollars, pre-tax profit of 8,200 million dollars. The capital required to operate the business is now 40 million U.S. dollars. This means that since 1972 , we only need to invest another $ 32 million to allow the company to achieve moderate real growth. During this period, See's total pre-tax income has reached 1.35 billion US dollars. All profits, except for $ 32 million, will be returned to Berkshire. 』
Unit: US$10,000 | When buying | last year | Increase rate |
Working capital | 800 | 4000 | 4 |
Net profit before tax | 500 | 8200 | 15.4 |
ROIC | 0.625 | 2.05 | 2.28 |
Without deducting the tax rate, we use the net profit before tax ➗ working capital (this is only an approximate calculation, and the actual analysis cannot be calculated like this), we can find the ROIC of Heath Candy .
From the chart, we can see that from the time of the purchase until Buffett’s current last year, his working capital increased four times, while the surplus increased 15.4 times. Readers can see that a slight increase in capital investment by Heath Candy can create profits several times the investment amount. And such enterprises are the first choice for investors.
2. Working capital growth = earnings growth
Such enterprises are very common. If an enterprise earns the same proportion of profits by investing capital, it is like increasing the bank's money from 100,000 to 1 million, and the interest also increases.
Unit: US$10,000 | Ten years ago | this year | Increase rate |
Working capital | 10 0 | 1000 | 9 |
Net profit before tax | 100 | 1000 | 9 |
ROIC | 1 | 1 | 0 |
It can be seen from the chart above that working capital and net profit before tax have increased simultaneously, but ROIC has not changed at all. In reality, such a situation is unlikely, but it is possible that ROIC is sluggish and the growth rate is very low. For example, ROIC will grow at an average annual rate of 1% over the long term , and it is difficult to have an amazing increase.
3. Working capital growth > Earnings growth
Unit: US$10,000 | Ten years ago | this year | Increase rate |
Working capital | 100 | 1000 | 9 |
Net profit before tax | 100 | 500 | 4 |
ROIC | 1 | 0.5 | -0.5 |
This type of company, with a certain amount of capital invested, can only earn half or less of its surplus. In the long run, the growth rate of ROIC is negative.
Virgin Atlantic Airways ( Virgin ) chief executive: "If you want to become a millionaire, a billionaire and then became the first to open an airline. 』
The aviation industry is the most standard example. The continuous expansion of the aviation industry’s fleet has brought high personnel, depreciation, and rental costs. This is a capital-intensive industry. Whether it is buying or leasing aircraft, it needs to invest a lot of costs, plus it is severely affected by oil prices. Fuel costs, as well as rising personnel costs, for various reasons make the aviation industry a difficult industry to make money.
In an unregulated and homogeneous commodity market, air ticket price competition makes it difficult for this market to profit.
From right to left, the data are 2010 , 2011... and so on. It can be seen from the chart that the ROIC of VISA has been on the upward trend during the ten-year period, while the downward trend during the period is sometimes due to the recognition of high goodwill and intangible assets through mergers or reorganizations, such as trademarks, Concession and so on. In the long run, VISA can make full use of these purchased assets and create profits.
Then we compare VISA 's ROIC and WACC relations
What is WACC? It measures the cost of capital of a company .
WACC = weight of debt * cost of after-tax debt + weight of common equity * cost of retained earnings + weight of special equity * cost of special shares
It can be expressed as WACC= (Wd)[( Kd )(1-t )]+ (Wp)( Kp )+ ( Wc )(Kc )
Wd : debt ratio, Kd : debt yield, Wp : preferred stock ratio, Kp : preferred stock return, Wc : common stock ratio, Kc : common stock return, t : tax rate
There are two main sources for companies to obtain funds from outside: equity and debt. Therefore , the capital structure of a company mainly consists of three components : preferred stocks, common stocks and liabilities (often bonds and promissory notes).
The weighted average cost of capital (ie WACC ) consider capital structure (that is, assets, liabilities, equity ratio of weight) relative weight of each component in weight and reflects the expected cost of the new asset for the company.
A company will want its WACC to be the smallest so that it can raise funds with the smallest capital cost.
ROIC represents the remuneration of capital, how much remuneration the management can create by capital investment: while WACC represents the cost of capital, which generally refers to the cost of raising funds. And the reason for evaluation is whether a company's operators can use the company's capital to create greater returns.
When ROIC is greater than WACC , it symbolizes that the management can make full use of shareholders' money, retain surpluses and liabilities to get higher returns for funds. If ROIC < WACC , it means that the management's ability to use debt and equity is mediocre or even poor.
From the chart, we can see that long -term ROIC is greater than WACC , which represents VISA's long-term borrowing and the profitability of using equity is very good.
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