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 take a look at Intel (NAS: INTC) 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
(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 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 Intel and three industry peers over a few periods.
1 Year Ago
3 Years Ago
5 Years Ago
Applied Materials (NAS: AMAT)
Texas Instruments (NAS: TXN)
Advanced Micro Devices (NYS: AMD)
Source: S&P Capital IQ. TTM=trailing 12 months.
*Because AMD did not report an effective tax rate, we used its 7.5% rate from one year ago.
Intel's returns on invested capital are significantly higher than that of the other companies, and its ROIC has shown solid growth from five years ago, suggesting its competitive position has improved. Advanced Micro Devices also has returns in the 20% range and also shows significant gains in those returns from five years ago. Applied Materials has returns approaching 20%, but they have declined by more than 13 percentage points from five years ago. Texas Instruments has the lowest returns of these companies and has also seen a significant decline from five years ago.
While Intel has had to deal with challenges related to a declining market for PCs, it has found some success in selling its PCs in emerging markets. Although the company has been able to increase its sales for mobile-device chips, some have criticized it for falling behind competitors in that area. For instance, ARM Holdings (NAS: ARMH) has managed to develop chip architecture that NVIDIA uses in its quad-core Tegra 3 processor. However, Intel is making moves to catch up in that area by releasing tablets and other mobile devices that use its Medfield chip.
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. Add these companies to your Watchlist:
Add Texas Instruments to My Watchlist.
Add NVIDIA to My Watchlist.
Add Intel to My Watchlist.
Add ARM Holdings to My Watchlist.
Add Advanced Micro Devices to My Watchlist.
Add Applied Materials 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 Intel.Motley Fool newsletter serviceshave recommended buying shares of Intel and NVIDIA and writing puts on NVIDIA. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.