The primary objective of any business is creating and sustaining value; yet it’s an ongoing challenge. This holds true regardless of profit motive. For-profit businesses want to create value for shareholders, nonprofit organizations want to create value for their donors and beneficiaries. However, measuring the value a business has created can be difficult. Oftentimes, growth or increased production efficiency is automatically seen as value creating. This doesn’t always hold true. The real question is, has the cost of that growth and production efficiency exceeded the cost of capital needed to realize it? And, how do you measure it?
The answer lies in the business’s core function. Every business has a purpose, a set of activities (supporting and primary) it performs to deliver a product or service to market. And every business needs money or capital to fund those activities. This is invested capital, which is comprised of either debt, equity or both. In order to survive, each business must simply receive more money from customers for the product or service than it costs to produce said product or service, and it must do it at an amount that exceeds its cost of invested capital.
For example, let’s say you start a business and deploy $1,000 of capital comprised of a $500 debt issuance and $500 equity contribution. With this capital, you sell products or services and pay expenses for the year. When the dust settles and the year closes, you end with net income of $70. Is this good news? It depends. At face value, it seems like you did well. Taking a closer look, that is a return on invested capital (ROIC) of 7% ($70 net income ÷ $1,000 invested capital), which isn’t bad but how does that compare to the cost to deploy the $1,000 capital? Let’s assume the debt is issued at 5%, ignoring income tax effects, and investors would like a return on their $500 investment of 15%. Therefore, the weighted average cost of capital (WACC) is 10% ((5% + 15%) ÷ 2). 7% return is less than 10%; in effect, you’ve lost value. In reality, the calculations are much more complex, ROIC should only consider core operations. Thus, it is necessary to remove non-operating components buried in your financial statements. Nonetheless, ROIC and WACC are important metrics to know, recognize and track.
How do we know this is valid? Because numerous statistical analyses on publically traded companies yield the same results: the more ROIC exceeds WACC, the higher the ratio of enterprise value to earnings (the earnings multiple); there is very high correlation between those two variables. So, are you creating value or destroying it?
To learn more about how RSM can assist with calculating and tracking these and other key metrics as well as understanding why they are important within the context of your business, contact RSM’s consulting professionals at 800.274.3978 or email us.