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 Dominion Resources (NYSE: D ) 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
Source: S&P Capital IQ. TTM=trailing 12 months.
Dominion Resources and NextEra Energy (NYSE: NEE ) have the highest returns on invested capital of the listed companies, with returns just above 5%. However, both of these companies have lower current returns than they did five years ago. Entergy (NYSE: ETR ) has the next highest ROIC at 4.4%, but its returns have also declined from where they were five years ago. FirstEnergy (NYSE: FE ) has the lowest returns of the listed companies, but also has the lowest returns it has had in the past five years and has seen relatively more volatility in those returns than the other listed utilities.
Dominion Resources has a variety of client types, serving some governmental properties and well as residential and corporate properties in several eastern states in the U.S., providing both natural gas and electricity. Also, it has the largest storage facility for natural gas in the U.S., which it has kept so it can continue its gas utility business even after selling its natural gas resources to CONSOL Energy (NYSE: CNX ) in 2010. The company has become increasingly involved in highly regulated areas of the utility industry. While this decreases its growth opportunities, it offers the benefit of more stable profits ongoing.
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: