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 Teck Resources (NYS: TCK) 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
(Get further detail on 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 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 Teck and three industry peers over a few periods.
1 Year Ago
3 Years Ago
5 Years Ago
Cliffs Natural Resources (NYS: CLF)
Cameco (NYS: CCJ)
Walter Energy (NYS: WLT)
Source: S&P Capital IQ. TTM=trailing 12 months.
*Because Cameco did not report an effective tax rate, we used a 35% rate.
Cliff's Natural Resources has returns on invested capital much higher than the other companies, but its ROIC has steadily and dramatically declined over the past three years, losing more than a third of its value from three years ago. Teck Resources has the next highest ROIC, and while it has steadily increased its returns over the past three years, its current value is much lower than what it was five years ago. Cameco's current returns have declined since last year but were steadily growing up to that point and are currently double what they were five years ago. Walter Energy's returns are currently below 7% and are the lowest they've been over the course of the five years.
Like Freeport-McMoRan Copper and Gold and Southern Copper (NYS: SCCO) , Teck Resources is involved in copper sales and production, which ties its success closely with the health of the global economy, since copper growth currently relies on infrastructure and housing growth in emerging markets.
Teck is also involved in metallurgical coal production, along with Alpha Natural Resources and Arch Coal. This area has seen some nice growth lately. But even though Teck has benefited from growth opportunities in these areas, challenges associated with the financial crisis put Teck in a position where it needed cash quickly, which forced it to sell its stake in Hemlo Mines at a very low price.
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. You can also add these companies to your Watchlist:
Add Walter Energy to My Watchlist.
Add Teck Resources to My Watchlist.
Add Southern Copper to My Watchlist.
Add Freeport-McMoRan Copper & Gold to My Watchlist.
Add Cliffs Natural Resources to My Watchlist.
Add Cameco to My Watchlist.
Add Alpha Natural Resources to My Watchlist.
Add Arch Coal 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 Freeport-McMoRan Copper & Gold. 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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