Effective Business Valuation 119liabilities are also subtracted out because they represent “ interest -
free ” loans. For example, if you own a shoe store and a supplier
extends you credit to buy and sell its shoes, no capital was dispensed
to get the use of the assets (the shoes), so this doesn ’ t go into the
IC equation. What we ’ re left with is the total invested capital. Many
different investors have subtle differences in the way they calculate
ROIC, but the general idea of what you are after is the same: the
return a business generates relative to the capital deployed to get
that return. When the return on capital is greater than the cost of
capital — usually measured as the weighted average cost of capital —
the company is creating value; when it is less than the cost of capi-
tal, value is destroyed.
Capital comes in two forms, debt and equity. Calculating the
cost of debt is relatively simple, as it is comprised of the rate of
interest paid on the debt. The cost of equity is a bit more compli-
cated, as equity typically does not pay a return to its investors. In
specifi c cases — such as real estate investment trusts and energy mas-
ter limited partnerships — the high dividend yield can represent an
accurate cost of equity, but in general, calculating the cost of equity
is not as clear - cut as calculating the cost of debt. Modern fi nance
theory uses the capital asset pricing model (CAPM) to determine
the cost of equity. Under the assumptions of CAPM, inputs such a
stock ’ s beta (or volatility) are used to determine the cost of equity
capital. Because value investors often disregard beta as an inap-
propriate measure of risk, the CAPM model is fl awed. The cost of
equity should merely refl ect the sum of the risk free rate of return
(refer back to the discussion on discount rate earlier in the chapter)
and an equity risk premium. Similar to the discount rate, the equity
risk premium will vary depending on the company in question. Wal -
Mart ’ s cost of equity, and hence its equity risk premium, will be a
lot less than the cost of equity for Ford Motor Company. Given the
market confi dence in the greater stability of Wal - Mart ’ s operating
revenues compared to that of Ford, investors will demand a lowerCH006.indd 119CH006.indd 119 9/2/09 6:58:10 PM9/2/09 6:58:10 PM