ROIC Analysis: Value Destruction From Growth And Other Pitfalls

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Something that might shock the average investor is that growth can actually lead to value destruction for a company, depending on how a company is achieving that growth. Using ROIC analysis and comparing it to a company’s cost of capital, we can quickly determine when that is happening and steer clear from these types of investments.

In order to understand why cost of capital is important, especially in its relation to ROIC (Return on Investment Capital), we need to understand what cost of capital is. Cost of capital can be thought of in two ways:

  1. The company’s cost of acquiring capital. This could be something as simple as the interest rate paid for new debts.
  2. The opportunity cost for investors. Going back to our simplified example, the company with a 1% ROIC is not doing the shareholder any favors when that money could’ve been reinvested elsewhere to earn higher returns, making an investment in the company as a whole a poor investment.

In either case, a company must earn a higher return on its capital than the cost of capital, otherwise it will drive its value to the ground. And in a rational market, a company can’t continue to earn lower returns (or ROIC) compared to its cost of capital, as eventually that value drops to zero. Let’s take a simplified example of a company whose cost of capital through debt funding is higher than ROIC, and thus destroys value.

Example: Cost of Capital and Value

Say our company’s cost to borrow is 8%, and their ROIC is 5%. Assume also that the initial value of the business is $10,000 and it earned $2,000 in the first year. Assume the company paid all of the $2,000 in earnings in a dividend, and then borrowed $3,000 over 10 years to fund expansion.

  • At a 5% ROIC, the company adds $150 in growth.
  • At a 8% cost to borrow, the company adds $240 in interest charges.

After you net the interest charges and new growth, the company actually earns $1,914 in profit the next year compared to the $2,000 from year one. Value is being destroyed. This is pretty obvious, as you can see growth is actually decreasing even though earnings are reinvested.

But value can be destroyed in a more sinister way, such as when the cost of capital refers to opportunity cost and can be harder to detect. Say the cost of capital for a company was still 8%, in this case they are issuing shares instead of adding debt.

The 8% of shareholder dilution will offset the growth from 5% ROIC, which nets a decrease in earnings per share even though the company itself grew $150 in earnings. From a company standpoint, the growth looks solid; from a shareholder perspective, value was obviously destroyed. Even that is obvious from an EPS perspective, though.

Where true opportunity cost matters is where a company’s cost of capital is higher than ROIC, which means if the company issued shares, they would’ve tangibly destroyed value, but maybe they didn’t actually do this explicitly. Instead, by reinvesting the earnings for growth at lower rates, the company compounded capital less optimally for the investor who could’ve put the money elsewhere.

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Disclosure: The author doesn't hold any securities that may be listed.

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