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 (ROIC) 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, ROIC divides a company's operating profit by how much investment it took to get that profit. The formula:
ROIC = Net operating profit after taxes / Invested capital
You can get further detail on the nuances of the formula.
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 it provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently 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%. We prefer to see ROIC above 12% at a minimum, along with a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.
Let's look at Altria Group (NYS: MO) 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
Lorillard (NYS: LO)
Reynolds American (NYS: RAI)
Philip Morris International (NYS: PM)
Source: Capital IQ, a division of Standard & Poor's.
Altria's returns on invested capital are the same as they were five years ago, suggesting that its competitive position is remaining intact under a tough regulatory environment. Lorillard's huge numbers are a result of its very low invested capital. The other companies have seen some level of growth in their ROIC over the same time period, and Philip Morris has seen dramatic growth in its ROIC from three years ago.
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. Warren Buffett has long loved healthy and growing dividends -- and you should, too.
So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. If you'd like, you can add these companies to your Watchlist:
Add Altria Group to My Watchlist.
Add Reynolds American to My Watchlist.
Add Philip Morris International to My Watchlist.
Add Lorillard to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., owns shares of Philip Morris. The Motley Fool owns shares of Philip Morris International and Altria.Motley Fool newsletter serviceshave recommended buying shares of Philip Morris and creating a bear put ladder position in Lorillard. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't 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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