How do companies destroy shareholder wealth?

It has been said that a company can create value for its shareholders when it generates a return on invested capital higher than its opportunity cost.

But when it fails to produce enough returns to cover its cost of capital, it means it is destroying shareholder wealth and its capital will be better spent somewhere else.

Previously, we have discussed that the residual spread of a company’s return on invested capital (ROIC) and its weighted average cost of capital (WACC) tend to move in tandem with its market share price.

The higher the spread between its ROIC and WACC, the higher the increase in share price, as reflected in the ratio of enterprise value-to-Invested Capital.

The Enterprise Value (EV), which is dependent on the performance of the share price of a company, represents the market capitalization, plus total net debt, while Invested Capital (IC) is the total amount of debt and equity contributed to the company.

In theory, the ratio of ROIC-to-WACC is supposed to be equal to the ratio of Enterprise Value-to-Invested capital (EV/IC) ratio.

If a company’s ROIC/WACC ratio is higher than its EV/IC ratio, it means the stock is undervalued, because the value created has yet to be recognized in the share price.

On the other hand, if the EV/IC is higher than the ROIC/WACC, it means the stock is overvalued, because the share price has gone way ahead of its added shareholder value.

For example, if we divide Aboitiz Equity Ventures’ ROIC at 7.5 percent by its estimated WACC, using the current 10-year bond yield, at 6.9 percent, we can get ROIC/WACC ratio of 1.08.

If we divide the stock’s enterprise value of P463 billion by its invested capital of P430 billion, we can also derive its EV/IC ratio of 1.08.

Because both ratios are equal, we can say the stock is fairly valued at current rates.

Now, if we expect the 10-year bond yield to continue to fall this month, we can expect the stock to have a lower WACC.

Lower bond yields mean lower WACC, which helps increase the ROIC/WACC ratio to rise closer to EV/IC level.

However, if the market expects its operating profits to disappoint, a breakdown in the share price may drag down its EV/IC ratio, which can be confirmed by a lower ROIC/WACC ratio later.

This situation is similar to what happened to the stock market early this year. The market was supposed to be undervalued because its average EV/IC ratio was 25 percent lower than its ROIC/WACC ratio.

But instead of staging a recovery, the market fell because the 10-year bond yield accelerated from 2.9 percent in January to 4.65 percent in March, which resulted in a sharp drop in ROIC/WACC ratio.

At one time, during the surge in bond yields, the fall in ROIC/WACC ratio against the EV/IC ratio overvalued the stock market by much as 32.8 percent.

It was only recently when the 10-year bond yield began to correct that it reduced the overvaluation to 17.8 percent. Further drop in bond yields with inflation easing may actually trigger a short-term rally in the market, as average ROIC/WACC improves.

But we know that a low WACC is not enough to sustain a recovery. Companies need to earn adequate returns to create value for shareholders.

Over the past years, the number of companies in the Philippine Stock Exchange index (PSEi) with negative returns has been increasing.

Prior to the COVID-19 pandemic, there were only two companies that have ROIC/WACC ratio lower than one in 2019. In 2020, as the coronavirus crisis unfolded, this number increased to 8 companies, roughly about one-third of companies in the index.

But this year, as the crisis continues to wreak havoc on the economy, the number of companies with deteriorating shareholder value has further increased to 10, which represents about 61 percent of the total market value of the PSEi.

This emerging trend is also confirmed by the falling average ROIC/WACC ratio in the market, which declined from 1.82 in 2019 to only 0.95 this year, so far.

Unless the economy recovers soon, a weakening ROIC/WACC ratio only means lower stock price valuations in the months ahead. INQHenry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 89th batch of RFP program this May 2021. To register, email [email protected]

or text at 0917-6248110