It’s essentially the 5Y ROIC. The key point of the article is that we should always compare it to the cost of capital - that’s how you truly measure a business’s value creation.
Current Assets > Total Equity > Total Liabilities > Current Liabilities > Non-Current Assets > Non-Current Liabilities
ROCE is very much larger than ROIC for stocks running light capital business model.
If you use ROCE, instead of ROIC, as P/E Multiple's Companion Variable, in determining the intrinsic value, you may end up buying extremely overvalued stock.
It reminds me of enterprise valuation metrics in the Investment Banking.
We mostly did a combo of different metrics to arrive at a seemingly reasonable value - ROIC, ROCE, EVA, FCFF + FCFE etc (ofcourse we were looking at the whole company for buyout so analysis varied)
Really solid post, love how you broke down why ROE can be misleading and made a strong case for focusing on ROIC vs. WACC. EVA is such an underrated concept and you explained it in a super clean way. One thing I would add is maybe a quick note that EVA can vary a lot across industries, and it might not always apply well to early-stage or fast-growth companies. But overall, this is the kind of post that actually helps people think deeper. Keep writing ✍️ - Best Regards, Ronak
“Investors should remember their scorecard isn't computed using the Olympic-diving method:
Degree-of-difficulty doesn’t count.
If you're right abt a business whose value is largely dependent on a single key factor that is both easy to understand & enduring, the payoff is the same as if you should correctly analyze an investment alternative characterized by many constantly shifting & complex variables.”
— Warren Buffett
ii。
“The higher return a business can earn on its capital, the more cash it can produce, the more value is created. Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.”
— Warren Buffett
iii。
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much difference than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”
— Charlie Munger
iv。
The P/E ratio of any company that's fairly priced will equal its growth rate. . . . If the P/E of Coca-Cola is 15, you'd expect the company to be growing at about 15 percent a year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year...and a P/E ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a P/E ratio of 12 is an unattractive prospect and headed for a comedown. . . . In general, a P/E ratio that's half the growth rate is very positive, and one that's twice the growth rate is very negative.
// Peter Lynch, One Up on Wall Street
v。
“Over the longest period of time .. your return approximates the business return to capital invested in the business itself over the long term. The two tend to really converge pretty closely.”
— Li Lu
vi。
“In short, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits.”
— Joel Greenblatt
vii。
“It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens.”
Interesting points. A combination of ROCE with ROE, and debt ratio can uncover hidden facts. Especially if business is generating return over cost of capital.
Instead of ROE, look at 5Y ROCE. It’s a metric which tells you a lot about the business
Well said, Siddharth!
It’s essentially the 5Y ROIC. The key point of the article is that we should always compare it to the cost of capital - that’s how you truly measure a business’s value creation.
For light capital business model:
Current Assets > Total Equity > Total Liabilities > Current Liabilities > Non-Current Assets > Non-Current Liabilities
ROCE is very much larger than ROIC for stocks running light capital business model.
If you use ROCE, instead of ROIC, as P/E Multiple's Companion Variable, in determining the intrinsic value, you may end up buying extremely overvalued stock.
An interesting perspective, Jimmy!
It reminds me of enterprise valuation metrics in the Investment Banking.
We mostly did a combo of different metrics to arrive at a seemingly reasonable value - ROIC, ROCE, EVA, FCFF + FCFE etc (ofcourse we were looking at the whole company for buyout so analysis varied)
Nice one, Charu! That’s pretty much it.
At the end of the day, equity research metrics align closely with investment banking - there’s a lot of synergy between the two.
Thanks for sharing your perspective!
Really solid post, love how you broke down why ROE can be misleading and made a strong case for focusing on ROIC vs. WACC. EVA is such an underrated concept and you explained it in a super clean way. One thing I would add is maybe a quick note that EVA can vary a lot across industries, and it might not always apply well to early-stage or fast-growth companies. But overall, this is the kind of post that actually helps people think deeper. Keep writing ✍️ - Best Regards, Ronak
EVA Value (formulated by the Nobel Prize Laureates Franco Modigliani and Merton Miller)
= Economic Spread × Invested Capital Per Share
= ( ROIC - WACC ) × Invested Capital Per Share
= 100 × EVA Per Share
= 100 × Residue Income Per Share
= 100 × Economic Profit Per Share
.
Note 1:
.
i。
Economic Value Added (EVA)
Residue Income (RI)
Economic Profit (EP)
.
EVA = RI = EP
.
EVA
= RI
= EP
= Economic Spread•Invested Capital
= (ROIC_Ratio - WACC_Ratio)•Invested Capital
= Net Profit - WACC_Ratio•Invested Capital
.
Note 2:
.
Basically EVA Value is extremely high.
.
The actual intrinsic value is very much lower.
.
If you bought a stock with exactly EVA Value, overall, you may end up earning nothing for the next 10 years.
Invested Capital is a modal, not related to the earning's power.
The composition of Intrinsic P/E is the variable of earning's power.
The closest to Earning's Power
= Growth and Profitabilities
= Gnp, ROIC, ROA which I strongly advocate
That leads to Individual PEG, PEROIC & PEROA Valuations.
Can we blend PEG, PEROIC & PEROA Valuations together to produce a single compromised balanced Valuation?
Your homework.
I just can’t seem to understand…
i。
“Investors should remember their scorecard isn't computed using the Olympic-diving method:
Degree-of-difficulty doesn’t count.
If you're right abt a business whose value is largely dependent on a single key factor that is both easy to understand & enduring, the payoff is the same as if you should correctly analyze an investment alternative characterized by many constantly shifting & complex variables.”
— Warren Buffett
ii。
“The higher return a business can earn on its capital, the more cash it can produce, the more value is created. Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.”
— Warren Buffett
iii。
“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much difference than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”
— Charlie Munger
iv。
The P/E ratio of any company that's fairly priced will equal its growth rate. . . . If the P/E of Coca-Cola is 15, you'd expect the company to be growing at about 15 percent a year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year...and a P/E ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a P/E ratio of 12 is an unattractive prospect and headed for a comedown. . . . In general, a P/E ratio that's half the growth rate is very positive, and one that's twice the growth rate is very negative.
// Peter Lynch, One Up on Wall Street
v。
“Over the longest period of time .. your return approximates the business return to capital invested in the business itself over the long term. The two tend to really converge pretty closely.”
— Li Lu
vi。
“In short, companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits.”
— Joel Greenblatt
vii。
“It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens.”
— Warren Buffett
Growth is crucial for ROIC sustainability because the invested capital is growing continuously.
Interesting points. A combination of ROCE with ROE, and debt ratio can uncover hidden facts. Especially if business is generating return over cost of capital.
Excellent post, one question- we generally use ROIIC— can we use incremental eva?