Think Value

Some business models inherently involve very small amounts of capital, making the use of ROIC (Return on Invested Capital) impractical for evaluation. When the scale of profit relative to the invested capital is very large, even small changes in profitability cause high volatility in ROIC. We encounter instances where ROIC is negative, making its use completely pointless.

Such business models are not only characteristic of low capital-intensive sectors like brokerage, consulting, auditing, and legal services but also possible in high capital-intensive companies that have outsourced their production capacities… for example, Nike or Apple.

In general, it is advised to be cautious with ROIC when its value exceeds 50%. In such cases, it is more convenient to use the Economic Profit calculation method. There are two formulas for calculating economic profit. It is because NOPAT-to-Revenue is more stable multiplier:

EP = (ROIC – WACC) * Invested Capital

EP = NOPAT – WACC * Invested Capital

Since economic profit is expressed in absolute numbers, its ratio to sales parameters is more stable and allows for comparisons over time as well as comparisons with competitors.

It is important to understand that the economic profit method yields the same result as the DCF (Discounted Cash Flow) method if the model is correctly constructed.

The formulas are as follows:

• Value₀ = Invested Capital₀ + Invested Capital₀ * (ROIC₁-WACC) / (WACC-g)
• Value₀ =Invested Capital₀ + Economic Profit₁/(WACC-g)

Economic Profit vs ROIC Excel Model

*Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels