Why ROIC alone isn’t a sufficient condition to judge returns
In the previous two parts of this series, we looked at Emerson Electric’s (EMR) ROIC (return on invested capital) on a stand-alone basis. However, we were only looking at half of the story.
For example, let’s assume that the ROIC of Company A is 15% and the ROIC of Company B is 10%. Is this a sufficient condition to conclude that Company A is creating more value than Company B? What if the weighted average cost of capital (or WACC) of Company A is 20% and Company B’s is 5%?
By generating 15% in ROIC, Company A is actually destroying value since its WACC is much higher at 20%. On the other hand, Company B, despite its low ROIC, is creating excess returns over its WACC, thus creating more value for its shareholders.
Emerson’s excess returns
For our analysis, we’ve looked at average yearly WACCs based on data provided by Bloomberg. Emerson’s excess returns have varied from 3.3%–10.3% in the 15-year period of 2000–2015. The average excess return in the most recent five-year period from 2011–2015 is 5.4%. The company’s excess returns of 9% in 2015 were impressive, but investors would generally like it to be more consistent.
Comparison with electrical equipment peers
The average excess return of companies in the electrical equipment industry (XLI) within the S&P Global 1200 Index was 3.7% in 2015. With an excess return of 9.5%, Emerson was ranked third out of 13 electrical equipment (IYJ) companies based on its excess returns.
Investment decisions are based on a company’s ability to generate returns in the future rather than in the past. This can only be understood by analyzing the business of the company, the industry’s structure, and the long-term potential for the company’s products.
We’ll be analyzing these details by looking at each of Emerson’s segments in the second series of this company overview, which will come out by September 4, 2016. To stay updated in the meantime, investors can subscribe to our industry newsletter.