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 Precision Castparts (NYS: PCP) 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
Alcoa (NYS: AA)
ArcelorMittal (NAS: MT)
Commercial Metals (NYS: CMC)
Source: S&P Capital IQ.
*Because AA did not report an effective tax rate, we used its 23% rate from TTM.
** Because MT did not report an effective tax rate, we used its 14% rate from three years ago.
***Because CMC did not report an effective tax rate, we used its 31% rate from three years ago.
Precision Castparts' returns on invested capital are lower than they were five years ago and have steadily declined over the past three years. The other companies have also seen declines in their ROIC from five 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. 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 Precision Castparts to My Watchlist.
Add Arcelor Mittal to My Watchlist.
Add Commercial Metals to My Watchlist.
Add Alcoa 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 Arcelor Mittal.Motley Fool newsletter serviceshave recommended buying shares of Precision Castparts. 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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