“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here, a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” – Warren Buffett, 2007 Chairman’s Letter for Berkshire Hathaway.
Invested capital is the amount of money that has been invested in a business for purchasing inventory, equipment, property, leases, and funding the difference between accounts receivable (i.e., how much money is owed by customers to the business) versus accounts payable (i.e., how much business owes vendors).
Return on Invested Capital (ROIC) is a financial ratio that shows a company’s ability to allocate capital. The standard formula to calculate ROIC is to divide a company’s after-tax net operating profit by the sum of its debt and equity capital.
Once the ROIC is calculated, it is evaluated against a company’s weighted average cost of capital, commonly referred to as WACC. If a company’s WACC is not immediately available, it can be calculated by taking a weighted average of the cost of a company’s debt and equity.
The cost of debt is calculated by averaging the yield to maturity for a company’s outstanding debt. This is easy to find, as publicly traded companies must report debt obligations.
The cost of equity is typically calculated using the capital asset pricing model, or CAPM.
Once the WACC is calculated, it can be compared with the ROIC. Investors want to see a company’s ROIC exceed its WACC. This indicates the underlying business successfully invests capital to generate a profitable return. In this way, the company is creating economic value.
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