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 read more 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 Apple (NAS: AAPL) 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
Dell (NAS: DELL)
Hewlett-Packard (NYS: HPQ)
Seagate Technology (NAS: STX)
Source: S&P Capital IQ.
*Because STX did not report an effective tax rate, we used its 13% effective tax rate from TTM.
Apple has seen steady declines in its returns on invested capital over the past five years, but it has the highest ROIC of these companies. Two of the other companies have also seen declines in their ROIC from five years ago, but Seagate Technology has improved its ROIC from five years ago. Dell's negative number from five years ago is due not to poor earnings, but rather to negative invested capital -- a favorable situation to be in.
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 Warren Buffett has long loved.
So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. Add these companies to your Watchlist:
Add Seagate Technology to My Watchlist.
Add Hewlett-Packard to My Watchlist.
Add Dell to My Watchlist.
Add Apple to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., owns no shares of any company mentioned here. The Motley Fool owns shares of Apple.Motley Fool newsletter serviceshave recommended buying shares of Dell and Apple and creating a bull call spread position in Apple. 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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