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The ROIC Curve

Valuation Framework

Content:
I. Theoretical Drivers of Firm Valuation
II. Why Focus on ROIC?
III. Using the ROIC Curve as a Screening Tool
IV. ROIC Curve Empirical Results
V. The ROIC Curve Versus Traditional Valuation Anomalies

This information is intended to be general in nature and should neither be construed as investment advice nor a recommendation of any
specific security or strategy.

Published October 2013. For financial professional use only. Do not distribute to the public.

Executive Summary

EXECUTIVE SUMMARY
This paper examines the effectiveness of various valuation drivers in screening for companies that are potentially
pre-disposed to outperform on a relative basis. Of the five drivers put forth by Merton Miller and Franco
Modigliani in their seminal 1961 work on valuation, our analysis narrows to one driver that has proven over
time to be an effective filter: Return on invested capital, or ROIC. This does not mean that Miller-Modiglianis
other drivers are any less important; our conclusion is that ROIC is better deployed in a screening phase of an
investment process and the other drivers, less effective as screens, are better utilized later in the fundamental
research phase of our investment process as validation or rejection of the screen findings. Based on our findings,
we believe:

ROIC is an effective, time-tested screen for finding companies with the potential to outperform

As an initial screen, it is superior to the four other Miller-Modigliani valuation drivers

The ROIC Curve, our proprietary screening mechanism, plots the relationship between ROIC and Enterprise
Value/Invested Capital (a proxy for market valuation) and effectively reveals which companies may be mis-
priced by the market and are therefore potentially pre-disposed to outperform

When coupled with rigorous fundamental research, which then includes other Miller-Modigliani measures
and other drivers, this screening mechanism has produced proven investment results over time

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Value Investment Philosophy

VALUE INVESTMENT PHILOSOPHY


Guggenheim Investments Value (GIV) strategy seeks
investment opportunities in which a companys longterm fundamental expectations and/or risk profile
implied by the current stock price are materially
different from our internal assessment of the firms
intrinsic value.
Our investment philosophy has the following key
components:

Bottom-up stock selection

Concentrated positions with portfolio weightings


based on relative conviction level

35 year average time horizon

Preference for companies with stable or


improving competitive positions

Sell discipline based on deteriorating fundamentals,


valuation materially exceeding internal estimate,
portfolio rebalancing (risk control), or better
investment opportunity elsewhere

Valuation and rigorous fundamental analysis


constitute the two core elements of our research

A key component of GIVs internal valuation


methodology is the ROIC Curve, a graphical
representation of the relative valuation of companies
across a benchmark universe. The ROIC Curve is
based on the relationship between a firms return on
invested capital (ROIC) and the ratio of enterprise

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value to invested capital (EV/IC). This relationship


is described in more detail later, but we begin with a
brief discussion of the academic valuation theory that
underpins the ROIC Curve and an explanation as to
why ROIC is a relevant factor for valuation screening.
With regard to quantitative measures, although we
utilize many metrics to establish a companys intrinsic
value, we believe that return on invested capital
is the most reliable and robust. We also point out
that intrinsic value is an effective risk-management
framework: Buying business at a discount doesnt just
offer a large potential upside; it also helps limit losses
by allowing for margin of safety if the investor is
wrong.
In sum, we believe that intrinsic value is a rational
approach that can help investors avoid being either
paralyzed or whipsawed by the markets irrationality,
volatility and often-conflicting messages. We find that
such dislocations can actually unearth many attractive
opportunities for astute investors, but that price charts
and other external indicators can easily lead investors
astray.
We believe that in order to find viable long-term
opportunitiescompanies that are currently earning
more than their cost of capital, have a record of
protecting capital and are in a strong competitive
position to grow that capital once the current
recession turns aroundinvestors must adopt a
bottom-up value framework.

Theoretical Drivers of Firm Valuation

I. THEORETICAL DRIVERS OF FIRM VALUATION


At the most basic level, the theoretical value of a firm
is equal to the present value of its future cash flows. In
their seminal 1961 paper, Merton H. Miller and Franco
Modigliani provide a breakdown of the components
that drive the discounted cash flow valuation of a firm:
Normalized net operating profit after tax (NOPAT)
A proxy for the current (or steady state) cash flow
generation of the firm, without accounting for future
reinvestment (growth) opportunities.
Return on invested capital (ROIC)
Return on the firms investments.
Reinvestment rate (growth)
Growth rate of NOPAT, based on ROIC less the

amount distributed to the firms investors (dividends,


share buybacks, and debt service).
Weighted average cost of capital (WACC)
Return demanded by investors based on the
fundamental risk of the firms cash flows.
Competitive advantage period (CAP)
Period over which a firm can generate ROIC that
exceeds firms WACC. Only growth related to
investments where ROIC exceeds the WACC will create
incremental shareholder value.
The ROIC Curve utilizes ROIC as the key driver of
valuation.

II. WHY FOCUS ON ROIC?


A reasonable question to ask is why GIV focuses
valuation screening on ROIC rather than the other
valuation drivers identified by Miller and Modigliani.
It is important to note that GIV investment
professionals integrate all of the valuation drivers in
their detailed fundamental analysis and construction
of discounted cash flow models. However, there
are several benefits to using ROIC for a quantitative
valuation screening methodology and certain
drawbacks to each of the other Miller and Modigliani
valuation drivers with regard to valuation screening.
There are five key attributes of ROIC that make it
a strong factor for valuation screening. The first
attribute is measurability. ROIC can be measured
relatively easily using readily available historical
financial data from a standardized database such
as Compustat. The second attribute, automation, is
closely related to measurability. ROIC can be compiled
in an automated fashion across a large universe of
companies, which provides the efficiency needed for a
screening tool. The third key attribute is fundamental
insight. Viewing valuation through an ROIC lens not
only results in a high quality screen, but ROIC itself
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provides fundamental insight about the type and


quality of business being studied. The fourth key
attribute is cross-factor correlation. ROIC provides
some incremental information about other valuation
drivers. An example is a companys growth rate. The
sustainable growth formula holds that without raising
additional capital, a firm cannot grow faster than its
ROIC, reduced by the amount of profits returned to
capital providers through buybacks, dividends, and
debt service. ROIC effectively acts as a cap on a firms
growth rate, and therefore ROIC and growth are
somewhat correlated. The final attribute of ROIC that
makes it a strong factor for screening is efficacy. As
we demonstrate in a later section with our backtest
results, ROIC has proven empirically to be strongly
correlated with valuation, and stock selection based
on discrepancies between a firms ROIC-based
warranted valuation and market valuation yields
positive alpha over time.
The other Miller and Modigliani valuation drivers,
while important to our overall fundamental process,
fail in one or more of the key attributes that make
ROIC a viable screening factor.

Why Focus on ROIC?

WACC and competitive advantage period suffer from


measurability and automation difficulties. NOPAT,
while measurable, suffers automation difficulties as
normalization of earnings is often necessary on an
industry-by-industry basis, and industries change over
time. Although academics have proposed several
models of WACC estimation, including the Capital
Asset Pricing Model (CAPM), these models have
difficulty measuring the equity risk premium and
therefore result in limited efficacy.

The competitive advantage period is not a directly


observable data item; it must be subjectively judged
by the fundamental analyst and therefore suffers from
measurability and automation difficulties.
The following chart in Table 1 compares the various
Miller-Modigliani drivers and confirms our hypothesis
of ROIC as an effective initial screen.
The last Miller and Modigliani valuation driver to

TABLE 1: ROIC VERSUS OTHER VALUATION DRIVERS

Measurability

Automation/
Efficiency

Fundamental
Insight

ROIC
NOPAT
GROWTH
WACC
CAP
Strong
Medium
Weak

ROIC
NOPAT
GROWTH
WACC
CAP

Return on invested capital


Normalized net operating profit after tax
Reinvestment rate
Weighted average cost of capital
Competitive advantage period

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Cross-Factor
Correlation

Efficacy

Why Focus on ROIC?

address, the firms growth rate, warrants a more


detailed discussion. There are two key problems
with using a firms growth rate as the key valuation
driver. The first problem is efficacy. Using a standard
discounted cash flow model based on the Miller and
Modigliani valuation drivers, we can demonstrate that
unless a firm has a high level of ROIC, changes in the
firms growth rate will not have as big of an impact on
valuation as an equally sized change in ROIC.
This fact is further illustrated by an analysis from

McKinsey & Co. in Exhibit 1 which depicts the impact


of a 1% change in both ROIC and growth on a firms
valuation (defined as enterprise value). The study
holds that a 1% delta in ROIC, given a baseline
ROIC of 9% for instance, results in a 26% increase
in valuation versus no change from a similar delta
in growth given the same base ROIC. Even though
the study finds diminishing returns to increasing
ROIC, the efficacy of ROIC over growth as a driver of
valuation is clearly demonstrated.

*EXHIBIT 1: IMPACT OF ROIC VERSUS GROWTH ON VALUATION

Value, Compared
Improving returns on invested capital creates more value than growth (except when ROIC is already high).
Value Created by 1% Faster Growth1 %

Value Created by 1% Higher ROIC1 %

26

16

6
Baseline ROIC

0
9

12

20

The second difficulty with a growth-based valuation


framework is that growth rates are highly unstable
and often very difficult to predict. Alternatively, ROIC
tends to be more stable and more predictable. Exhibit
2, also courtesy of McKinsey, demonstrates this fact
by comparing the migration of ROIC and growth levels

*SOURCE: MCKINSEY & CO. 1 Assumes 9% weighted average cost of capital.


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7
Baseline ROIC

12

20

of individual companies between 1994 and 2003. For


example, 50% of firms with an ROIC of over 20% in
1994 remained above 20% in 2003, while only 13% of
firms with a growth rate of over 20% in 1994 remained
above 20% in 2003.

Why Focus on ROIC?

*EXHIBIT 2: PERSISTENCY OF ROIC AND GROWTH, 19942003

Individual companies can sustain a high ROIC ...


3-year average ROIC without goodwill of all publicly listed U.S. companies with real revenues >$200 million %

ROIC in 2003
510%

<5%

1520%

1015%

>20%

ROIC in 1994
<5%

43

510%
1015%

28

12

31

40
25

21

1520%

18

>20%

19

17
25

19

6
18

17

25

13

13

% of Companies
that Stayed the
Same

11

11

20

50

% of Companies
that Moved to a
Higher Level

% of Companies
that Moved to a
Lower Level

... but cannot sustain growth


3-year compound annual growth of real revenues of all publicly listed U.S. companies with real revenues
>$200 million %

Revenue Growth in 2003


Revenue Growth
in 1994

510%

<5%

<5%

67

15

1015%

1520%

>20%

7
5

510%

64

16

12

1015%

61

15

11

11

59

1520%

56

>20%
% of Companies
that Stayed the
Same
*SOURCE: MCKINSEY & CO.

For financial professional use only. Do not distribute to the public.

11
13

14
10

% of Companies
that Moved to a
Higher Level

13
% of Companies
that Moved to a
Lower Level

Why Focus on ROIC?

EXHIBIT 3: EXAMPLE OF ROIC CURVERUSSELL 2500TM ROIC CURVE


6

y = 15.998x2 + 1.548x + 1.376


R2 = 75.10%

EV / IC

4
3
2
1

-10% -5%

0
0%

5%

10% 15% 20% 25% 30% 35% 40%


ROIC

Exhibit 3 shows the ROIC curve. The formulaic


definitions for EV/IC and ROIC are as follows:
EV = market value of equity + book value of debt
cash & short term investments
IC = book value of equity + book value of debt
ROIC = pretax earnings / IC (as defined above)
ROIC is calculated using trailing four quarter data and
excludes nonrecurring or extraordinary items. EV and
IC are both adjusted to reflect operating leases as debt
capital.
The use of EV/IC as the metric for market valuation is
important because it adjusts for the firms debt level.
This adjustment is significant because equity investors
claim on the firms cash flows is subordinate to
creditors. Using a metric such as P/B or P/E does not
capture differential debt loads among firms and thus
risks overlooking an important economic difference
in comparing firms. Cash is also excluded from EV in
order to isolate the valuation of the ongoing operating
business of the subject company.
The use of ROIC to measure profitability is also
instrumental to this valuation framework for two
reasons. First, ROIC is superior to profit marginFor financial professional use only. Do not distribute to the public.

based profitability metrics, such as pre-tax margin or


net income margin, because ROIC accounts for the
capital required to generate profits. Pre-tax margin
at best only captures the cost of debt capital (via the
expensing of interest costs). Second, ROIC captures
the return to all investors in the firm, whether debt or
equity. Using an alternative measure such as return on
equity (ROE) to capture profitability does not account
for differential use of financial leverage among firms
to achieve common equity profitability.
Exclusion of the Financial Sector from the ROIC Curve
The two largest subsets of the financial sector
banking and insurancehave unique attributes
relative to industrial sectors that require the exclusion
of the financial sector from the ROIC Curve. In the
banking industry, the high degree of financial leverage
makes the calculation of ROIC not meaningful.
In the insurance industry, leverage is primarily
operating rather than financial in nature because the
key leverage statistic is premiums written to equity.
This type of leverage is impossible to capture in the
ROIC Curve framework. Additionally, both banks and
insurance companies have significant uncertainty in
profit reporting due to the heavy use of accruals (i.e.
provisioning for credit losses in banking and booking
reserves in insurance). This uncertainty generally
causes financial services companies to trade at a
significant discount to the broader market.

Using the ROIC Curve as a Screening Tool

III. USING THE ROIC CURVE AS A SCREENING TOOL


The first step in drawing a conclusion from the ROIC
Curve is to determine whether there is a discrepancy
between the companys current EV/IC based on
market price and the warranted valuation based on
the relevant ROIC Curve benchmark. The warranted
valuation can be determined relative to one of three
benchmark ROIC Curves: 1) the broad market, 2) the
subject companys industry, and 3) the companys own
history (adjusting for any changes in ROIC over time).
Assuming a similar risk profile and growth outlook,
the market should assign the same value to a unit
of ROIC regardless of what company generates it.
Therefore, if there is a large discrepancy between
the subject companys EV/IC and the warranted EV/
IC based on one of the three benchmarks identified
above, a mispricing of the security could be present.
We refer to this discrepancy as delta Y because
it is the vertical distance on the graph between the

companys valuation and the corresponding point on


the benchmark curve. A large positive delta Y implies
overvaluation of the subject company, while a large
negative delta Y implies undervaluation. Our basic
screening process using the ROIC Curve is to screen
for companies that have a large negative delta Y. An
illustration of delta Y is depicted in Exhibit 4.
It is important to note that the presence of a large
negative delta Y does not guarantee undervaluation of
a security. The ROIC Curve does not capture the other
four components of Miller & Modiglianis theoretical
valuation framework. These other factors could be
materially higher or lower than the benchmark group
of companies against which we are comparing the
subject company. It is the primary function of our
fundamental research to perform an in-depth industry
and company analysis to assess whether the security
is truly mispriced.

EXHIBIT 4: ROIC CURVE WITH "DELTA Y"RUSSELL 2500TM ROIC CURVE


6

y = 15.998x2 + 1.548x + 1.376


R2 = 75.10%

5
4
EV / IC

10

Positive "delta Y"


potential overvaluation
Stock A

2
1

-10% -5%

0
0%

Stock B
Negative "delta Y"
potential undervaluation
5%

10% 15% 20% 25% 30% 35% 40%


ROIC

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ROIC Curve Empirical Results

11

IV. ROIC CURVE EMPIRICAL RESULTS


GIV has performed a rigorous empirical backtest
for the ROIC Curve to demonstrate that when a
companys valuation diverges significantly from its
warranted EV/ICROIC relationship, opportunities for
excess return (alpha) may be present. The backtest
was performed by splitting the investment universe
into deciles based on delta Y, with stocks showing
the largest negative delta Y (i.e. highest potential
undervaluation) in decile 1. A summary of the results
of this backtest across the market capitalization

spectrum from 1986 to 2010 are presented in


Exhibit 5. The charts show the annualized absolute
return of each decile over the relevant benchmark,
using a 3-year time horizon, which is consistent with
our typical holding period.
The backtest results show a strong positive correlation
between delta Y and superior investment returns, as
measured by absolute return.

EXHIBIT 5: ROIC CURVE BACKTEST RESULTS1ANNUALIZED ABSOLUTE RETURN OVER


BENCHMARKS (BY DECILE)
8%
7%
6%
5%
4%
3%
2%
1%
0%

8%

R1000 Annualized Active Returns vs. Benchmark

10

R2500 Annualized Active Returns vs. Benchmark

6%
4%
2%
0%
-2%
-4%
-6%

10

5%
4%
3%
2%
1%
0%
-1%
-2%
-3%

8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
-10%

RMidCap Annualized Active Returns vs. Benchmark

10

R2000 Annualized Active Returns vs. Benchmark

10

Past performance is no guarantee of future results.

Delta Y Deciles from 19862012, 3-Year Holding Period. Decile 1 represents largest negative delta Ys; GICS sectors equal weighted to avoid large sector bias.

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The ROIC Curve Versus Traditional Valuation Anomalies

V. THE ROIC CURVE VERSUS TRADITIONAL VALUATION ANOMALIES


While we have addressed why GIV uses ROIC rather
than the other Miller-Modigliani valuation drivers as
a key factor for valuation screening, there remains
the question as to why the ROIC Curve methodology
is superior to other valuation anomalies that have
been identified by academic researchers over time.
Examples of these anomalies include low price-toearnings (P/E), P/E-to-growth (PEG), price-to-book
(P/B), and enterprise-value-to-EBITDA (EV/EBITDA).
We believe that these traditional valuation metrics
suffer from significant shortcomings that fail to
account for the key theoretical drivers of firm valuation
as proposed by Miller-Modigliani.
Traditional valuation multiples that are based on the
ratio of equity market price to current earnings, cash
flow, or some proxy for either (such as EBITDA) are
weak because they do not provide any insight as to
the returns generated by a firm and whether or not
those returns are in excess of the cost of capital.
From Miller-Modigliani we know this is critical to
shareholder value creation.

Valuation metrics that are based on the relationship


of steady-state earnings (or cash flow) multiples
to growth in earnings (cash flow), such as the PEG
ratio, suffer from the shortcomings we identified
in an earlier section of this paper (see Why
Focus on ROIC?), as well as a key shortcoming
common to the other basic multiples: they do
not indicate whether the growth generated is
economically profitable (i.e. ROIC > WACC). Without
understanding the ROIC profile of the firm, we
cannot make an informed judgment about market
valuation. Exhibit 6, courtesy of Legg Mason Capital
Management, illustrates the theoretical relationship
of P/E to growth and ROIC.
Exhibit 6 shows that if a firm is reinvesting at its cost
of capital (and no more), the P/E ratio will not change
regardless of an increase in growth rate. If the firm
reinvests below the cost of capital, its P/E ratio will fall
as growth increases, because the firm is destroying
shareholder value.

*EXHIBIT 6: THE RELATIONSHIP OF P/E TO ROIC AND GROWTHRETURN ON INVESTED CAPITAL

Earnings Growth

12

4%

8%

16%

24%

4%

6.1x

12.5x

15.7x

16.7x

6%

1.3

12.5

18.1

20.0

8%

NM

12.5

21.3

24.2

10%

NM

12.5

25.5

29.9

Assume all equity finance; 8% cost of capital; 20-year forecast period

*SOURCE: LEGG MASON CAPITAL MANAGEMENT.


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The ROIC Curve Versus Traditional Valuation Anomalies

Beyond all of the shortcomings related to earnings


and growth-based measures of valuation, there is
one additional problem related to valuation multiples
that use equity market price and/or book value as a
component of valuation: They do not differentiate
firms by financial leverage (debt), and they do not
account for excess cash held by a firm. For example,
two firms with identical operating profiles might trade
at far different P/E multiples because one uses far
higher financial leverage. The firm with higher leverage
justifiably trades at a lower multiple because it has
increased bankruptcy risk and equity earnings volatility
due to the high degree of financial leverage.

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13

Beyond a discrepancy in debt levels, two firms could


have identical operating profiles but one firm has
a significant amount of excess cash. The firm with
excess cash could justifiably trade at a higher P/E
multiple, assuming all other fundamental factors
about the two firms were identical. Thus the existence
of different amounts of debt in the capital structure
and excess cash would diminish the reliability of
comparative valuation using P/E multiples. This
problem is mitigated using the ROIC Curve because
valuation is measured using Enterprise Value, which
accounts for debt and cash.

14

Conclusion & References

CONCLUSION
Given GIVs long-term investment horizon and
concentrated position sizes, it is critical that our
investment professionals maintain an intimate
understanding of each of our investment positions.
The rigorous depth of research conducted on each
investment opportunity is both enabled and focused
by having a screening mechanism that allows our
team to narrow their research to opportunities that are
pre-disposed to outperform and subject to extensive
fundamental research, and have a high probability

of inclusion into the investment portfolio. Thus we


avoid wasting resources researching securities with
low-probability of success and utilize that time honing
our research on better opportunities. The ROIC Curve
provides that small subset of promising opportunities
to our investment professionals and also yields initial
insights about the fundamental quality of a company
that serve as a starting point for our fundamental
research.

REFERENCES
Cao, Bing; Jiang, Bin; and Koller, Timothy, "Balancing
ROIC and Growth to Build Value," McKinsey on
Finance, Spring 2006.
Mauboussin, Michael J., M&M on Valuation,
Mauboussin on Strategy, 14 January, 2005.
Miller, Merton H. and Franco Modigliani, Dividend
Policy, Growth, and the Valuation of Shares, The Journal
of Business, October 1961.

The information provided here is intended to be general in nature and should not be construed as investment advice nor a
recommendation of any specific security or strategy.
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