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, 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
(You can read more about 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 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 Chico's (NYS: CHS) 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
Talbots (NYS: TLB)
ANN (NYS: ANN)
Coldwater Creek (NAS: CWTR)
Source: S&P Capital IQ.
*Because CHS did not report an effective tax rate, we used its 35.6% rate from one year ago.
**Because TLB did not report an effective tax rate, we used its 36.4% rate from five years ago.
***Because CWTR did not report an effective tax rate, we used its 40% rate from five years ago.
Chico's returns on invested capital are less than half of what they were five years ago, suggesting that its competitive position has declined, but retail can be a very tough world. Two of the other companies have also seen dramatic declines in their ROIC over the past five years, while ANN's margins have grown slightly over the same time period. This suggests that the decline in ROIC is more of an industrywide problem than something specific to Chico's.
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. Add these companies to your Watchlist:
Add Talbots to My Watchlist.
Add Coldwater Creek to My Watchlist.
Add Chico's FAS to My Watchlist.
Add ANN to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., owns no shares of any company mentioned here. 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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