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 PetMed Express (NAS: PETS) 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
VCA Antech (NAS: WOOF)
MWI Veterinary Supply (NAS: MWIV)
IDEXX Laboratories (NAS: IDXX)
Source: S&P Capital IQ.
PetMed Express' returns on invested capital are far higher than the other companies', but they have declined dramatically from five years ago. Still, it has fairly consistently maintained an ROIC in the mid-70s, suggesting that it is managing to keep its competitive position. Two of the other companies have also seen declines over the same time period, while MWI Veterinary Supply's ROIC has steadily increased.
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 VCA Antech to My Watchlist.
Add PetMed Express to My Watchlist.
Add MWI Veterinary Supply to My Watchlist.
Add IDEXX Laboratories 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 PetMed Express.Motley Fool newsletter serviceshave recommended buying shares of VCA Antech.Motley Fool newsletter serviceshave recommended creating a covered call position in VCA Antech. 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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