{"concept":{"id":60,"slug":"cost-of-capital","term":"Cost of capital","shortDefinition":"The minimum return a company should generate to justify the capital it has invested -- the benchmark ROIC is compared against.","longDefinition":"The cost of capital is the minimum return a company should generate to justify the capital it has invested -- the opportunity cost of employing that capital in this business instead of an alternative with similar risk. It's the benchmark ROIC is compared against: if a company's ROIC exceeds its cost of capital, the business is creating real value -- it generates more than it costs to finance it. If ROIC falls below the cost of capital, the business destroys value, even if it's accountably profitable and shows positive profit on its income statement."},"relations":{"requirement":[],"contrast":[],"related":[{"concept":{"id":58,"slug":"roic","term":"ROIC","shortDefinition":"The after-tax return a company generates on all the capital invested in its business -- debt and equity together -- regardless of how it's financed.","longDefinition":"ROIC (Return on Invested Capital) measures how much after-tax operating income a company generates in relation to all the capital invested in its business -- financial debt and equity together, without distinguishing which of the two it comes from. After-tax operating income is used, not gross operating income or net income: gross would ignore the real effect of taxes on profitability, and net income would carry the effect of how the company is financed (interest on debt), exactly what ROIC seeks to isolate. Unlike ROE, which only compares profit with equity, ROIC doesn't change if a company decides to finance itself with more debt and less of its own capital, or vice versa -- it measures the performance of the business itself, not the effect the financing structure has on that performance. That's why ROIC complements ROE instead of replacing it: ROE says how much the shareholder earns on their capital; ROIC says how much the business earns per euro employed in it, whoever that euro belongs to."}},{"concept":{"id":76,"slug":"wacc","term":"WACC","shortDefinition":"The precise calculation of the cost of capital: the weighted average of the cost of debt and the cost of equity, according to each one's weight in the company's financing.","longDefinition":"WACC (Weighted Average Cost of Capital) is the precise specialization of the cost of capital, already covered in general terms in Level 2 and used that way by ROIC and DCF. WACC combines the after-tax cost of debt and the cost of equity, each weighted by its relative share in the company's total financing: the greater the proportion of debt versus equity, the more the average leans toward debt's cost -- generally lower -- and vice versa. The result is a single discount rate, but not an exact, unquestionable figure: it depends directly on the estimates of its two components -- particularly the cost of equity, sensitive to CAPM's assumptions -- and on the financing weights used. It's the figure ROIC compares against business returns, and that DCF uses to discount its future flows, now calculated precisely instead of estimated in general terms."}}],"calculatedBy":[{"concept":{"id":68,"slug":"dcf","term":"DCF","shortDefinition":"A valuation method that estimates a company's value by projecting its future cash flows and bringing them to present value.","longDefinition":"DCF (discounted cash flow) is a valuation method that estimates a company's value from two pieces: the present value of the cash flows it will generate during an explicit forecast period -- usually five to ten years -- and the terminal value, which captures the value of all the flows it will generate beyond that period. Both pieces are discounted to present value using a rate that reflects the company's cost of capital. It's one of the two main families of valuation methods -- alongside comparable multiples -- and its result depends critically on the starting assumptions: the projection of future flows, the assumed long-term growth rate, and the discount rate used."}}]},"curricularPosition":[{"id":47,"moduleId":16,"slug":"what-is-roic-versus-the-cost-of-capital","title":"What is ROIC versus the cost of capital?","summary":"You understand what the cost of capital is in general terms, and why comparing ROIC with the cost of capital is what really indicates whether a company creates or destroys value.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you understand what the cost of capital is in general terms, and why comparing ROIC with the cost of capital is what really indicates whether a company creates or destroys value.\n\n## Content\n\nThe previous lesson left ROIC calculated -- how much after-tax operating income a company generates on its invested capital. But a positive ROIC, on its own, isn't enough to judge whether a company is creating value. A reference point is missing: the cost of capital.\n\nThe cost of capital is the minimum return a company should generate to justify the capital it has invested -- the opportunity cost of employing that capital in this business instead of an alternative with similar risk. If a company's ROIC exceeds its cost of capital, the business is creating real value: it generates more than it costs to finance it. If ROIC falls below the cost of capital, the business destroys value -- even if it's accountably profitable and shows positive profit on its income statement.\n\nThis distinction is what really separates a quality business from one that simply \"doesn't lose money.\" A company can show positive net income, positive ROE, and positive ROIC, and still be destroying value if that ROIC doesn't cover what its invested capital costs -- growth in a business like that isn't necessarily good news for its shareholders, even if the accounting figures look healthy.\n\nCalculating the cost of capital precisely requires weighting the cost of debt and the cost of equity for a company -- a methodology outside the scope of this module. What matters here is the criterion: it isn't enough for ROIC to be positive, it has to exceed that minimum reference point for the business to really be creating value.\n\nWith this lesson, the module closes. The next module in this level introduces specific margins -- gross, operating, and net -- which up to now have only been treated as the general concept of margin.\n\n## Example\n\nTwo companies can have the same ROIC of 8%, but if one operates in a low-risk sector with a cost of capital of 5% and the other in a high-risk sector with a cost of capital of 10%, the first is creating real value and the second is destroying it, even though both show exactly the same ROIC.\n\n## Common mistakes\n\n- Judging a company as a value creator just for having a positive ROIC, without comparing it with its cost of capital.\n- Assuming two companies with the same ROIC are in the same situation, without accounting for the fact that their cost of capital -- tied to their business and sector risk -- can be very different.\n\n## Summary\n\nThe cost of capital is the minimum return that justifies the capital invested in a company. Comparing ROIC with the cost of capital -- not just checking whether ROIC is positive -- is what indicates whether a company creates or destroys real value.\n\n## Self-check\n\nWhy can a company with positive accounting profit, even so, be destroying value?\n\nWhy can two companies with the same ROIC be in very different situations depending on their cost of capital?","bodyHtml":"<h2>Objectives</h2>\n<p>By the end of this lesson you understand what the cost of capital is in general terms, and why comparing ROIC with the cost of capital is what really indicates whether a company creates or destroys value.</p>\n<h2>Content</h2>\n<p>The previous lesson left ROIC calculated -- how much after-tax operating income a company generates on its invested capital. But a positive ROIC, on its own, isn't enough to judge whether a company is creating value. A reference point is missing: the cost of capital.</p>\n<p>The cost of capital is the minimum return a company should generate to justify the capital it has invested -- the opportunity cost of employing that capital in this business instead of an alternative with similar risk. If a company's ROIC exceeds its cost of capital, the business is creating real value: it generates more than it costs to finance it. If ROIC falls below the cost of capital, the business destroys value -- even if it's accountably profitable and shows positive profit on its income statement.</p>\n<p>This distinction is what really separates a quality business from one that simply &quot;doesn't lose money.&quot; A company can show positive net income, positive ROE, and positive ROIC, and still be destroying value if that ROIC doesn't cover what its invested capital costs -- growth in a business like that isn't necessarily good news for its shareholders, even if the accounting figures look healthy.</p>\n<p>Calculating the cost of capital precisely requires weighting the cost of debt and the cost of equity for a company -- a methodology outside the scope of this module. What matters here is the criterion: it isn't enough for ROIC to be positive, it has to exceed that minimum reference point for the business to really be creating value.</p>\n<p>With this lesson, the module closes. The next module in this level introduces specific margins -- gross, operating, and net -- which up to now have only been treated as the general concept of margin.</p>\n<h2>Example</h2>\n<p>Two companies can have the same ROIC of 8%, but if one operates in a low-risk sector with a cost of capital of 5% and the other in a high-risk sector with a cost of capital of 10%, the first is creating real value and the second is destroying it, even though both show exactly the same ROIC.</p>\n<h2>Common mistakes</h2>\n<ul><li>Judging a company as a value creator just for having a positive ROIC, without comparing it with its cost of capital.</li><li>Assuming two companies with the same ROIC are in the same situation, without accounting for the fact that their cost of capital -- tied to their business and sector risk -- can be very different.</li></ul>\n<h2>Summary</h2>\n<p>The cost of capital is the minimum return that justifies the capital invested in a company. Comparing ROIC with the cost of capital -- not just checking whether ROIC is positive -- is what indicates whether a company creates or destroys real value.</p>\n<h2>Self-check</h2>\n<p>Why can a company with positive accounting profit, even so, be destroying value?</p>\n<p>Why can two companies with the same ROIC be in very different situations depending on their cost of capital?</p>","sortOrder":2,"readingMinutes":10,"difficulty":"Intermedio","url":"/en/academy/business-analysis/roic/what-is-roic-versus-the-cost-of-capital"}],"graphSummary":{"root":{"type":"concept","id":"60","depthFromRoot":0,"entity":{"type":"concept","slug":"coste-de-capital","term":"Coste de capital","excerpt":"Rentabilidad mínima que debería generar una empresa para justificar el capital que tiene invertido -- el punto de referencia frente al que se compara el ROIC."}},"depth":1,"returnedNodes":1,"truncated":false,"hasCycle":false,"nodes":[{"type":"concept","id":"60","depthFromRoot":0,"entity":{"type":"concept","slug":"coste-de-capital","term":"Coste de capital","excerpt":"Rentabilidad mínima que debería generar una empresa para justificar el capital que tiene invertido -- el punto de referencia frente al que se compara el ROIC."}}],"edges":[]},"relatedNews":[],"relatedEntities":[]}