Of WACC, ROIC, AND HEALTHCARERobert M. Goldman, CFA
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Think of WACC, or weighted average cost of capital, as the fee a firm pays to its investors to make an investment. WACC is defined as:
Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Re, or cost of equity, can be calculated with the Capital Asset Pricing Model (CAPM), as:
Re = rf + (rm – rf) * β
Re = the required rate of return on equity
rf = the risk free rate
rm – rf = the market risk premium
β = beta coefficient = unsystematic risk
That’s a good amount to digest, although it’s quite basic for any market aficionado, MBA, CFA, or Jeopardy contestant.
Without getting into the boring complexities, let’s agree that given the above, WACC will increase with higher interest rates, lower tax rates, and higher share prices.
And isn’t that exactly where we are going? After all, the stock market is at a high, President Trump wants to lower taxes, and the Federal Reserve is on a path to increase interest rates.
So, I suspect WACC will be increasing. And that’s OK, as long as a company’s return on invested capital (ROIC) is higher than its WACC – simply meaning that the company’s profits on projects funded by its investments are in excess of the fees on the funds acquired from investors to make these investments.
Seems to me, that we’re heading into an environment where ROIC will be viewed increasingly as a virtue.
Yahoo! Finance provides a nice free screening tool, and ROIC is one of the screening metrics. Here’s the link; https://finance.yahoo.com/screener. Plenty of healthcare companies have ROIC in excess of WACC. We’re not in the business of recommending stocks, but Happy Hunting.