We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital in order to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.
ROIC is perhaps the most important metric in value investing. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's actually creating value for you. Simply, it divides a company's operating profit by how much investment it took to get that profit. The formula is:
ROIC = Net operating profit after taxes / Invested capital
The nuances of the formula are explained in further detail here. This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficient the company uses capital.
Ultimately, we're looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.
Let's take a look at PPL (NYS: PPL) and three of its industry peers, to see how efficiently they use cash. Here are the ROIC figures for each company over a few periods.
1 year ago
3 years ago
5 years ago
Calpine (NYS: CPN)
Dominion Resources (NYS: D)
Progress Energy (NYS: PGN)
Source: Capital IQ, a division of Standard & Poor's. *Because CPN did not report an effective tax rate for TTM, three years ago, or five years ago, we used a 35% effective tax rate.
PPL's returns on invested capital are 2 percentage points lower than they were five years ago, suggesting that its competitive position is growing weaker. Progress Energy has also seen declines in its ROIC, while the other two listed companies have grown their returns over the same time period.
Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.
So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. If you'd like to add these companies to your watchlist or set up a new watchlist, just click here.
At the time thisarticle was published Jim Royal, Ph.D., does not own shares of any company mentioned here.Motley Fool newsletter serviceshave recommended buying shares of Dominion Resources. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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