Applied Valuation by Clifford S. Ang

Author:Clifford S. Ang
Language: eng
Format: epub
Publisher: De Gruyter
Published: 2023-01-30T09:09:52.194000+00:00

4.3

Return on New Invested Capital

The first term on the right-hand side of Eq. (4.9) is the return on new invested capital (RONIC), which is the return on incremental or new capital that is invested into the company. This is not the same as return on invested capital (ROIC), which is the return that we expect to get from all the capital invested in the company, which includes both old capital and new capital. What this means is that old capital may earn a return that is different from the return we expect from new capital and that ROIC reflects that blend.

As an example, suppose we previously invested $100 million to buy a factory and we were able to generate $10 million of NOPAT from that factory. Our ROIC in Year 1 is 10%. Now, in the second year, suppose the old factory generated $10 million in NOPAT again. However, we invested an additional $10 million in a new plant and that new plant generated $3 million in NOPAT. The RONIC in this case is 30% (= $3 million NOPAT of new plant / $10 million of invested capital in new plant), while the ROIC is 11.8% (= ($10 million NOPAT from old factor + $3 million NOPAT from new plant) / ($100 million original capital + $10 million in new capital)).

Over the long term, competition would drive down any returns on new invested capital down to the cost of capital. When the company’s RONIC is equal to the cost of capital, the firm does not make excess returns. Every dollar we put in will just earn its cost, so we do not generate any value from the investment (i.e., the net present value is zero). If there are positive excess returns, companies can make economic profits and that will entice competition to enter and that competition will drive down returns. The greater competition causes returns to fall below the cost of capital for some firms and those firms will suffer economic losses. Eventually, firms that consistently suffer economic losses will leave the market. The remaining firms can increase returns again due to less competition. This process repeats until firms that survive only return their cost of capital.

The above tells us that in a competitive market, we would expect RONIC to equal WACC over the long term. We may expect this to occur when the company reaches steady state because the company’s competitive advantages at that point may have been competed away. Even if a company has a competitive advantage now, it is difficult to claim that the company can continuously protect that competitive advantage and/or consistently generate new competitive advantages into perpetuity. For example, companies may generate a competitive advantage because of patent protection, but patents have a finite life. Also, consumer preferences change, so something that may be popular today may no longer be popular 10 or 15 years from now. Therefore, if we were to assume that the firm has a sustainable competitive advantage that would have a RONIC that exceeds WACC into perpetuity, we have to be able to justify that choice.

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