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, or ROIC, in order 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 put, 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
The nuances of the formula are explained in further detail here. 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 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%. 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 Activision Blizzard (NYS: ATVI) 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
Electronic Arts (NAS: ERTS)
Take-Two Interactive Software (NAS: TTWO)
Sony (NYS: SNE)
Source: S&P Capital IQ. TTM=trailing 12 months. NM = not measurable because of a lack of financial statements.
*Because Activision Blizzard did not report an effective tax rate, we used its 18% rate from one year ago.
**Because Electronic Arts did not report an effective tax rate, we used a 20% effective tax rate.
***Because Take-Two did not report an effective tax rate, we used its 20% rate from three years ago.
Activision Blizzard's returns on invested capital have grown steadily and dramatically over the past three years, and the company has the highest current returns of the listed companies. The other listed companies have returns in the negative numbers in the last four quarters, suggesting that video games have been a tough industry to thrive 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 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. If you'd like to add these companies to your watchlist, click below:
Add Take-Two Interactive Software to My Watchlist.
Add Sony to My Watchlist.
Add Electronic Arts to My Watchlist.
Add Activision Blizzard to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., owns shares of Activision.The Motley Fool owns shares of Activision Blizzard and Take-Two Interactive Software. The Fool owns shares of and has written calls on Activision Blizzard.Motley Fool newsletter serviceshave recommended buying shares of Take-Two Interactive Software and Activision Blizzard.Motley Fool newsletter serviceshave recommended creating a synthetic long position in Activision Blizzard. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not 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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