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, to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.
In this series, we examine several companies in a single industry to determine their ROIC. Let's look at AT&T (NYS: T) and three of its industry peers, to see how efficiently they use cash.
Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's 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
(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 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.
Here are the ROIC figures for AT&T and three industry peers over a few periods.
1 Year Ago
3 Years Ago
5 Years Ago
Sprint Nextel (NYS: S)
Verizon Communications (NYS: VZ)
Vodafone (NAS: VOD)
Source: S&P Capital IQ. TTM=trailing 12 months.
*Because T did not report an effective tax rate, we used its 35% rate from three years ago.
**Because S did not report an effective tax rate, we used its 23% rate from five years ago.
***Because VOD did not report an effective tax rate, we used its 28% rate from three years ago.
AT&T's returns on invested capital have steadily declined over the past five years. Two of the other companies have also seen declines in their ROIC from five years ago, suggesting that the telecom sector is difficult right now. However, Verizon has increased its returns by more than 4 percentage points from five years ago.
AT&T has made several attempts to gain a competitive advantage over the past few years. For example, it has largely abandoned its slower-growth landline business and focused its energies on the higher-growth mobile business. It was also previously an exclusive provider of Apple's (NAS: AAPL) iPhone, which Verizon's and Sprint Nextel's networks now carry as well. If successful, AT&T's future plan to offer bundle plans with voice, video, and high-speed data services to both mobile and household devices also brings some hope of future competitive advantages.
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. Feel free to add these companies to your Watchlist:
Add Verizon Communications to My Watchlist.
Add Vodafone Group to My Watchlist.
Add AT&T to My Watchlist.
Add Sprint Nextel 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 Vodafone Group 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.
Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.