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.
In this series, we take a look at several companies in a single industry to determine their ROIC. Let's take a look at TJX (NYS: TJX) 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 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.
Here are the ROIC figures for four industry peers over a few periods.
1 Year Ago
3 Years Ago
5 Years Ago
The TJX Cos.
Source: S&P Capital IQ. TTM = trailing 12 months. *Because Macy's did not report an effective tax rate, we used its 36% rate from one year ago. **Because Saks did not report an effective tax rate, we used its 26.5% rate from TTM.
TJX has the highest returns on invested capital of the listed companies, and while it has fallen several percentage points since last year, it has grown its ROIC dramatically from five years ago. Kohl's (NYS: KSS) has the second ROIC, and after a dramatic drop three years ago, it has steadily increased its returns. Macy's (NYS: M) has returns on invested capital at almost 11%, and it has steadily increased its returns over the past three years. Saks (NYS: SKS) has also increased its returns over the past three years, but they're still nothing spectacular, suggesting the company is still having significant problems.
TJX's business model has allowed it to perform better than many other retailers during the recession by offering products from celebrated brands at a discount. Its model also helps other higher-end stores get rid of excess inventory while making a bit of money. TJX is not without competition in this area, with companies such as Big Lots (NYS: BIG) , DSW, Ross Stores, and Overstock.com also finding some success with TJX's business model. In a space known for cutthroat competition, it looks like TJX has managed to carve out a competitive advantage, at least as shown by its strong and growing ROIC.
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 The TJX Cos. to My Watchlist.
Add Saks to My Watchlist.
Add Ross Stores to My Watchlist.
Add Overstock.com to My Watchlist.
Add Macy's to My Watchlist.
Add Kohl's to My Watchlist.
Add DSW to My Watchlist.
Add Big Lots to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., does not own shares of any company mentioned here. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.