Measuring a business’s economic moat is a challenge, but there is a comparison using several metrics that allow us to get an economic moat idea. That comparison is the grudge match of finance, WACC vs. ROIC.
Warren Buffett speaks numerous times about his fondness for companies with economic moats. Many of his best investments, such as See’s Candies, Coca-Cola, and American Express, all have economic moats.
Those moats allow the business to raise its prices over the years, all while expanding its profits. All while reinvesting in their businesses with incremental costs, compared to the growing assets.
One of Buffett’s superpowers is the ability to look into the future and anticipate how his companies will perform. As mere mortals who don’t have that superpower, we need to find another way.
That way is the use of WACC vs. ROIC.
In today’s post, we will learn:
- What is WACC: An Overview
- What is ROIC: An Overview
- What is the Difference Between WACC and ROIC?
- Measuring Economic Moat
Okay, let’s dive in and learn more about WACC vs. ROIC.
What is WACC: An Overview
Before we compare the two metrics, let’s look briefly at both sides of the comparison.
WACC is an acronym for the weighted average cost of capital. The WACC represents a blend of costs of capital across all sources.
The sources include common shares, preferred shares, and debt. Its percentage of total capital weighs the cost of capital and then added together.
The WACC is a mash-up of both debt and equity and its weights, comparatively, and many use the WACC as a discount rate for financial modeling.
The WACC also acts as a minimum expected return in a discounted cash flow and other valuation methods such as a dividend discount model and an excessive return model.
The WACC includes in its formula:
- Equity risk premium
- Risk-free rate
- An average yield of debt
As we can see, WACC takes elements of your investment’s equity or risk and the impact of debt and its interest payments.
The formula for WACC below:
WACC = (E/V x Re) + (D/V) x (Rd x (1 – T))
And the inputs:
|E = Market Cap |
D = Market Value of the Company’s Debt
V = Total value of Capital = Equity plus Debt
E/V = % of capital that is equity
D/V = % of capital that is debt
Re = Cost of equity or required rate of return
Rd = cost of debt or yield to maturity on existing debt
T = tax rate
The purpose of WACC is to determine the cost of each part of the company’s capital structure based on the portion of equity, debt, and preferred stock of the company.
Each component of the formula has a cost to our company. Each company pays a fixed rate of interest on its debt and preferred stock.
Even though a company doesn’t pay a fixed rate on its equity, it may pay dividends in the form of cash to its stockholders.
The WACC is an important piece of the DCF model, and it is an important concept for everyone to understand, especially if you are trying to value companies.
If you want a much deeper dive into the formula and how to calculate it, please check out below:
What is ROIC: An Overview
On the other side of our comparison is the ROIC, or return on invested capital. The ROIC is a profitability or performance ratio that measures the percentage return that a company earns on invested capital.
The ROIC tells us how efficiently a company is using the investor’s monies to generate income. Companies like to use ROIC as a benchmarking to calculate the value of competitors.
Warren Buffett talks throughout his shareholder letters about moats and measuring a companies moat. The most common example is See’s Candies, and he explains his thoughts on return on invested capital using the company as an illustration.
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”
Buffett speaks about finding these diamonds in the markets, and once you do, make sure you “back up the truck.”
We calculate ROIC by taking the cost of investment and the returns generated from that investment. The returns are all the earnings after taxes but before interest payments. We calculate the investment by subtracting all current long-term liabilities from the assets.
The investment cost is either the total assets required for the business or the amount of financing raised by debt or equity sales.
Next, we divide the return by the cost of investment.
Return on Invested Capital (ROIC) = Net Operating Profit After Tax (NOPAT) / Invested Capital
A note, NOPAT is also equal to EBIT x (1 – tax rate)
If you would like a deeper dive into ROIC, check out below:
Okay, let’s look at the differences between WACC and ROIC.
What is the Difference Between WACC and ROIC?
The whole point of analyzing financials is determining if the company’s assets generate returns that exceed the cost of funding those assets.
And the next question, once we determine those returns: will those excess returns continue?
The answer to the first question lies in the past, thus analyzing the company’s assets and earnings or cash flows those assets generate. That is the essence of the return on invested capital formula to measure the assets and its impact on its earnings.
To give you a simple example of why this is important.
See’s Candies, from Buffett’s initial investment, grew from $4 million in earnings to $27 million on assets of $17 million. See’s earned $27 million on $17 million in employed assets, or 150% return on invested capital!
Not too bad.
So what does WACC have to do with this?
Plenty, the WACC is a measurement of the cost of debt and equity expressed as a percentage, which tells us how much we should expect in return for investing in that company.
Because both formulas look at both the cost of equity and the cost of debt, they tell us how much those costs equal the rate of return we should expect.
But if the ROIC is greater than the WACC, then the company is creating value because the company is investing in value-creating projects.
Yet, if the ROIC is lower than the WACC, then the company is destroying its value because the projects it is investing in are lower than the costs of funding that project.
As Buffett mentions, you look for businesses that create more value with their projects than destroy them.
The basic idea is that ROIC tells us how efficient the company is in generating greater returns than its costs to create those returns.
When beginning to analyze any company, the first item to investigate is the returns on invested capital. Remember that the ROIC is the return the company earns on its invested capital.
We are looking for higher returns on invested capital from each company we analyze, but not every company or sector will be apples to apples.
Comparing the ROIC of Apple to Walmart is not a fair comparison because the nature of each company’s assets is different. Also, comparing Microsoft to Apple is not a fair comparison as they are not competitors.
However, comparing Intel to AMD, Walmart to Target, or Wells Fargo to Bank of America is far more reasonable.
Where a company’s ROIC is less than its WACC doesn’t make it a poor investment now. If the company is attempting to rid itself of its non-performing assets, then the company’s fortunes might right itself.
It is always best to think through the investments and understand the reasons for management’s decisions before acting on them.
Measuring the Economic Moat
As we have explored the differences between the ROIC and WACC, we have seen that both formulas measure both debt and equity’s impacts on the company’s returns.
Using the differences between the formula can help us determine a company with a moat.
Remember that it doesn’t guarantee that a company with a wide gap between the ratios does indeed have a moat.
Instead, it tells us the company is efficient in creating earnings from the assets the company owns.
The sector the company operates in matters in this equation as well. For example, the ROIC of a company like Visa will be much higher than the Bank of America because of the capital-light business’s nature.
To see this action, let’s look at some sector ROICs and compare them to a few actual businesses. While also comparing those companies WACC for each business.
I will not walk through each calculation; if you have any questions about how these formulas work, please refer back to the above links.
The total ROIC for the market is 7.31% per Damodaran.com, with a range of 12.96% excluding financials.
The data above is from January 2020, and Professor Damodaran updates the data each year in January.
Let’s pick out a few sectors for us to compare several companies.
|Beverages (Soft) |
Okay, now that we have some comparisons for a few sectors, let’s take a couple of companies from each sector and compare their ROICs and WACCs to each other and their sectors.
A quick note, I will pull the numbers from gurufocus.com for ease of comparison, but by all means, feel free to calculate these numbers yourself.
Also, unless notated, all numbers will be TTM (trailing twelve months) for ease of comparison.
First up, let’s look at Coke and Pepsi; makes the most sense, huh?
- ROIC – 10.22
- WACC – 3.95
- ROIC – 11.48
- WACC – 4.29
Now, looking at both companies, we can see they have a gap between their ROICs and WACCs, but that also both are below the sector average of 26.21%
Without knowing the exact reason for this, I can hazard a few guesses.
First, the averages were calculated early in the year before the pandemic; also, interest rates were higher at the beginning of the year, and the impact on sales declines have impacts on the ROIC.
And if we look closely at the ROIC over the last four years for Pepsi, we see that the current TTM is lower than that period:
- 2016 – 12.85
- 2017 – 8.94
- 2018 – 22.32
- 2019 – 12.13
Looking further, we can see the second and third quarters were lower at 8.95%, and 10.16% respectively.
All that tells us is the pandemic impacted Pepsi efficiency, but it also indicates a company with strong fundamentals as it was able to withstand the pandemic’s impacts and remain profitable over that time.
Let’s look at another sector, retail, and use Walmart (WMT) and Target (TGT) for comparison.
- ROIC – 8.73%
- WACC – 3.37%
- ROIC – 12.59%
- WACC – 6.14%
At first blush, it looks like Target earns greater returns on its invested capital with a greater spread between ratios.
And if you look over the five years of returns available to view, we can see a consistent ROIC vs. WACC, which tells us that Target is doing a great job creating value from its assets.
Now, if we take this comparison a step further and include Amazon in this mix, we see:
- ROIC – 11.37%
- WACC – 8.46%
We can see that the spread is closer than either Walmart or Target. Why is that?
Several factors might contribute to that; first, Amazon is a complex company in that its retail is made up of different components and is making money, but its margins are smaller than we might think. Second, the AWS (Amazon Web Services ) segment is highly profitable but not enough to overcome the smaller margins of the retail segment.
These are all great questions to ask as we assume our Sherlock Holmes persona to investigate each company.
Okay, let’s take the next sector, semiconductors, and we will use Intel (INTC) and AMD as our guinea pigs.
- ROIC – 18.89%
- WACC – 4.10%
- ROIC – 38.66%
- WACC – 13.33%
As we can see, AMD is quite efficient and has quite a spread between its ratios, plus they are exceeding the sector average. Intel has a good spread and exceeds the sector; their growth is not as explosive as AMD.
Remember that the cost of equity helps drive the ROIC, and a company such as AMD has a high beta, which all things being consistent will drive up the cost of equity.
Compare that to Intel’s current beta, which is quite a bit lower than AMD’s of 2.08, at 0.58. That alone will drive down the cost of equity, which decreases the WACC.
But AMD has a greater revenue growth than Intel, which helps drive up the ROIC.
My point with these observations is not to illustrate which company is better than the other. Instead, I am trying to point out ideas worth exploring as we dive into these analyses.
For our last comparison, software, let’s compare Google and Facebook.
- ROIC – 21.29%
- WACC – 7.14%
- ROIC – 38.75%
- WACC – 9.35%
As we can see from above, both companies exceed the sector average of 20.03%, which is great.
And we can see that Facebook has a superior edge in the gap between ROIC and WACC.
Why do you think Facebook carries the superior gap between the ratios?
My thought is, without looking at the financials, is that Facebook does a fantastic job of monetizing its platform at a lower cost to create that money than Google does.
After a brief look at some financials, I can see that Facebook has a sizeable lead in margins across the board, from Gross to Net, plus they generate higher levels of free cash flow than Google.
All of which leads to lower needs for financing and higher retained earnings levels. All of which leads to better use of its assets in the long run.
FAANG Stocks Comparison:
- ROIC – 38.75%
- WACC – 9.35%
- ROIC – 23.82%
- WACC – 8.30%
- ROIC – 11.37%
- WACC – 8.46%
- ROIC – 11.94%
- WACC – 6.54%
- ROIC – 21.29%
- WACC – 7.14%
Briefly looking at each comparison, we can see that Amazon and Netflix have the closest gaps in ratios, while the other three all have pretty healthy gaps between ratios.
Just for giggles, let’s look at a couple more media darlings.
- ROIC – 4.60%
- WACC – 12.39%
- ROIC – 3.22%
- WACC – zero
- ROIC – (69.22)
- WACC – 9.30
I am not trying to pass judgment on any of the above companies, but I am trying to illustrate that we need to do our due diligence before buying any company, especially if it is “popular” on the news.
The ROIC and WACC are both powerful formulas to help investors determine the financial strength of any company we are analyzing.
Using both formulas in conjunction can help us determine a company that is efficient in using its assets to grow its earnings and finding great projects to reinvest those earnings.
Under a lot of fire for not paying a dividend, Buffett speaks of buying companies that generate better returns by reinvesting in themselves than they would by offering a 2.5% dividend or buying back its shares.
He believes that if the company does a fantastic job reinvesting in itself as does Facebook or See’s Candies, then those returns will outshine any dividend or buyback in the long run.
Time will tell if he is correct, but I like the odds.
Remember that the relationship between the two ratios helps us determine a company with a possible moat, enabling them to raise their prices while still growing the business.
Those are the diamonds we are seeking to find.
With that, we wrap up our discussion on ROIC vs. WACC.
As always, thank you for taking the time to read today’s post. And I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,