ROIC's role in investing

Hi,

I am wondering what role ROIC plays in investing - why do value investors like it that much when a company has high ROIC?

I get it that a company creates a lot of value if its ROIC is as high as possible and if its WACC is lower than its ROIC by as much as possible, but how does this add value exactly if the stock traides at fair value and we disregard psychology -> will the stock's price rise by more if the difference between its ROIC and WACC is higher?

please refer to the first answer @ https://www.quora.com/Stocks-financial/D...pected-too

Thanks if someone can help me out...

Regards,

Laszlo

(26-10-2013, 09:03 PM)LVidos Wrote: Hi,

I am wondering what role ROIC plays in investing - why do value investors like it that much when a company has high ROIC?

I get it that a company creates a lot of value if its ROIC is as high as possible and if its WACC is lower than its ROIC by as much as possible, but how does this add value exactly if the stock traides at fair value and we disregard psychology -> will the stock's price rise by more if the difference between its ROIC and WACC is higher?

please refer to the first answer @ https://www.quora.com/Stocks-financial/D...pected-too

Thanks if someone can help me out...

Regards,

Laszlo

This is probably best explored with theories of economic value added (EVA).

With regard to your hypothetical question, we must not confuse ourselves. Roic is computed on book values and not market values. A fairly priced company with a large roic gap over it's wacc will trade at a large premium to book value. If a stock is fairly priced and markets have perfect information, the shareholder will receive the company's required return on equity. The gap between roic and wacc is irrelevant if the market has accounted for it in the form of a p/b multiple.

As to why investors like high roic companies, that is a practical question. In theory, a high roic company and low roic company will have different p/b ratios but both will produce expected returns as long as expectations play out. Does a high roic company's shares command higher expected returns? I think it depends. Debt capital has generally been seen as cheaper than equity capital and a low wacc can imply high leverage. In such a case, it's equity securities will carry higher financial risks and the market will demand higher expected returns.

In reality, the market does not have perfect information or homogenous expectations and shares are not always fairly priced. A high roic company is seen to more likely to be a high quality company and have a competitive advantage that enabled them to sustain such high returns. As long as the business is scalable, this enables such companies to create more economic value by reinvesting it's retained earnings at high roic.

The idea is to try to capture the economic value created by such companies without paying a high price for it. That's why there is a difference between a good stock and a good company. A good company generates economic value above it's wacc, but might not be a good stock if the extra value is already priced in.

My CFA is rusty now but EVA is to compare your cost of capital vs your return on capital. The former is WACC and the latter is ROIC. ROIC is more akin to ROA than ROE because it is the return on total capital which includes all forms of financing including equity, debt or hybrids and even WC.

Fundamental research is primarily concerned on how much cashflow can be derived from the amount of capital that is being put in. The rest are all approximations to this end.