Value Creation and WACC in Financial Analysis

When fundholders invest capital in a business, they expect some return on their investment. This return is calculated as RoCE. But how will you determine whether the company has generated enough RoCE?

This opens up the discussion on value creation. In the upcoming video, Marie-Lys will explain the concept of value creation in detail.

In this video, you learnt the following stakeholders have claim on the RoCE:

Therefore, there is a need to calculate the after-tax RoCE, which will be directly available as a reward to the shareholders and bankers.

You also learnt the following criteria for value creation: 

In the upcoming video, our faculty, Marie-Lys will explain how to quantify the minimum return expected by the shareholders and bankers. 

As you learnt in this video, the minimum return required by shareholders and bankers is known as the weighted average cost of capital (WACC). WACC can be calculated using the following equation:

• WACC = Cost of debt x Proportion of debt + Cost of equity x Proportion of equity

The cost of equity depends on the risk perceived by the investors. If the share price of a company is highly volatile during crisis situations, investors perceive their investment in such companies as risky, and the required return on equity for such a company will be very high. 

You also saw that the TOTAL group had an after-tax RoCE of 9.8%, and comparing this against the WACC of the oil and gas industry revealed that the company had generated value for the year 2019. You also saw the RoCE and value creation graph for the company ATOS. 

In the next segment, you will learn about return on equity.

Additional Resource

• Industry-wise WACC by Prof. Aswath Damodaran

Note: This is a highly useful link that keeps getting updated with recent values. We suggest that you bookmark this link for future reference to the WACC of the different industries.

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Transcript of the Video: 

We've discussed the RoCE at length. But you may still have a question, how much is a good
enough RoCE? That relates to the idea of value creation in finance.
So, we're going to touch on that and that will also give us an opportunity to wrap up everything
we've seen so far.

So, in business, when we are looking at performance, we always make sure to separate the
operations from the financing activities.

They obey different logics and everything starts from the operations. At operating level, in order to
generate the profit, which we call the operating income, the operating managers are using some
resources.

Which resources? Well, buildings, machines, tools, and money to fund the operating cycle. We put
some jargon words on that concept.

So, in order to generate an operating income, we use property, plant and equipment, and more
generally speaking, fixed assets plus operating working capital.

Fixed assets, operating working capital together, that represents the so-called capital employed.
So, the name of the game in business is to max up the profit, the operating income, while
minimising the resources involved, minimising the capital employed.

And the metric that captures best these two dimensions is the return on capital employed, the ratio
of those two dimensions.
Then let's go one step further and let's ask ourselves who gets a reward, who is entitled to get a
reward on the return on capital employed?
Who has a claim on the return on capital employed delivered by the operations? First, the
government through taxes.

And second, the financing parties, namely the shareholders and the banks. They are the ones who
invested some capital that we're now employing to run the operations.

Let's look at an example with numbers. In the previous case, we were looking at the return on
capital employed was 22.5%. And if I remember well, we had a tax rate of one-third.
So, it means one-third of our return on capital employed is going to go to the government. And
two-third will be left to reward the financing parties, the shareholders, and the bankers together.
If I'm not mistaken, two-third of 22.5%, that's 15%. This is what we call the after tax RoCE. The
fraction of the RoCE that is left after paying taxes to the government.

And this is the one the financing parties are interested in because this is when they can get a
reward after tax.

By the way, remember, when we were looking at the Total example, the numbers were also taken
after tax because the communication was intended to shareholders, bankers that take a reward
after tax.

So, operations did their best, generated a 22.5% performance. And now 15% is left for the
financing parties together.

So, the key question is, is 15% high enough as compared to their expectations? If the answer is
yes, if 15% is matching their expectations or is even more than their expectations, then the
company will be said to have created value.

On the other hand, if the financing parties, shareholders and banks altogether were expecting
more than 15%, they'll be disappointed and they will say that the company destroyed value.

That may be frustrating for operating people who may feel like, hey, we did our best. And we
managed to deliver 22.5, that represented huge efforts on our side.
But in the end, the 15% left is disappointing for the shareholders and the bankers. That's not
enough. Your best is just not enough and that's very frustrating.
So, the question you may have is, I mean, how do shareholders, bankers set their expectations?
How can I know if I am above or below expectations when I deliver a certain return on capital
employed?

Well, this minimum level of return expected by shareholders and bankers is usually what we call
the WACC. WACC is an acronym that stands for weighted average cost of capital.

Actually, we're using money from shareholders and banks in different proportions. So, we're going
to compute the average cost of shareholder money and bank money, weighted by the proportion
of debt and equity we hold.

If you're interested, you may want to visit the website of an American professor who's computing
at the beginning of every year, the WACC per industry sector on sample companies, based in the
US essentially.

There is a long, long list of industry sectors. But what I like very much in this table is that it gives a
very clear view on how the WACC is computed.

Let's take the example of the automotive industry. You can see quickly that the computation is
based on the proportion of equity, E divided by D plus E because E stands for equity and D stands
for debt.

And the proportion of debt a little later on the table. D divided by D plus E. So, let's have a look.
In the invested capital, for example, in the automotive industry, 37.75% of our funds is equity. That
comes at a cost of 7.61%.

Then we have 62.25% of our capital, that is, debt. And that comes at a cost of 2.45%. So, on
average, how much does the invested capital costs?

Well, we do the average between 7.61% cost of equity, and 2.45% cost of debt weighted by the
proportions of debt and equity.

And at the end of the day, you get to a WACC of 4.40% in the automotive industry. If you ask
yourself, where does the cost of equity come from? How come it is 7.61% in the automotive
industry? That's very precise, isn't it?

Well, I invite you to dig further into your research, and you will quickly realize that this all depends
on the risks perceived by investors.

Investors usually carry very well diversified portfolio of shares. So, what they're interested in is
measuring the non-diversifiable level of risks they are taking.

For example, if there is a big economic shock, or if a pandemic is starting, then several industry
sectors will be hit and we will be facing some non-diversifiable risks.

So, in such situations, how volatile is a share likely to be? The higher the volatility of the share
price, the higher the risk we are taking as investors.

The higher return we want on our investments, and therefore, the higher the cost of equity. This is
all based on historical data in the past 40-50 years.
Nobody has a crystal ball, so we need to rely on past data. And probably few investors had
forecasted something like the COVID 19 pandemic that started to hit us end of 2019 or 2020.
So, that's where the WACC number is going to come from. Following up upon the Total example,
remember they were showing up a 9.8% return on capital employed after tax.

So, we can directly compare this to the WACC of Total. If you look in the long list of industry
sectors on that website I'm suggesting, we are going to find oil and gas integrated, and you should
read a WACC that is slightly above 7%.
So, Total showing a 9.8% performance is definitely above it's WACC. I don't know how much the
WACC Total is, but I can see that on average in this industry sector, oil and gas integrated, we
have WACC around 7, 7.3, 7.4%.
So, definitely Total was above its WACC, Total can say in 2019, we created value. They don't
communicate exactly in that way, comparing their RoCE to the WACC.
They let the financial analysts do that, but some companies do communicate on how good they
are, vis-a-vis their WACC.

So, for example, we can have a look at Atos, a consulting company that does a lot of business in
India.
That's not necessarily a top performer in their industry. I know some Indian companies are really
over-performing Atos.
But look at this slide, I took out one of their financial communications. Here, it's very clear. They
are showing up on screen that own return on capital employed.
And there is this slight note at the top right that mentions the numbers are taken after tax. So,
that's the one that can be challenged against the WACC.
They are proud to say that 2015, 2016, that will be above the average in the industry because that
wasn't really the case in the past years.
And in any case, they've been above their WACC since 2012, let's say. Not really 2011, but 2012.

So, that's the type of communication you can truly find from some companies. And that's the whole
story of value creation that applies here when we compare RoCE to WACC when looking at past
performance.

But the same underlying concept is at work when we speak about future value creation.
When companies say they are likely to create value, it means they will deliver more than what is
expected from them. And companies destroy value when they are below expectations.
Of course, value destruction cannot last long, which investors would stay in a company forever if
they never ever have a chance to get a sufficient return on their investments.