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 Akamai (NAS: AKAM) 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
Internap Network Services
Level 3 Communications
Source: S&P Capital IQ. TTM=trailing 12 months.
*Because Internap did not report an effective tax rate, we used a 35% rate.
**Because Limelight Networks did not report an effective tax rate, we used a 35% rate.
***Because Level 3 did not report an effective tax rate, we used a 35% rate.
Akamai Technologies has by far the highest returns on invested capital of the listed companies, and it offers the kind of steady growth that we like to see, suggesting its competitive position is improving. Limelight Networks (NAS: LLNW) has returns in the low negative numbers. Internap Network Services' (NAS: INAP) ROIC is also currently in the negative, but barely. In fact, throughout the five-year period, the company has thrown out low-to-negative numbers. Level 3 Communications (NYS: LVLT) has current returns just barely in the positive, but offered negative returns in two of the listed years, and its only positive returns were below 1%. Those low numbers suggest the companies are not able to earn a decent return on their investments.
Akamai suffered a setback in 2010 when it lost the competitive advantage resulting from its previous status as Netflix's exclusive provider for streaming video. Akamai's reign ended in 2010 when Limelight Networks and Level 3 Communications joined the party. The company has some hope for future growth associated with the growing amount of content on the Internet, which could increase the demand for Akamai's data delivery technology. However, other companies already compete in that space. In fact, companies like EdgeCast and Cotendo have found ways to increase their presence in that space by landing major clients like Google.
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 Netflix to My Watchlist.
Add Level 3 Communications to My Watchlist.
Add Limelight Networks to My Watchlist.
Add Internap Network Services to My Watchlist.
Add Google to My Watchlist.
Add Akamai Technologies to My Watchlist.
At the time thisarticle was published Jim Royal, Ph.D., does not own shares of any company mentioned here.The Motley Fool owns shares of Google.Motley Fool newsletter serviceshave recommended buying shares of Google and Netflix. 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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