We'd all like to invest as successfully as the legendary Warren Buffett does. He calculates return on invested capital (ROIC) to help determine whether a company has an economic moat -- the ability to earn returns on its money beyond that money's cost.
ROIC is perhaps the most important metric in value investing. 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, ROIC divides a company's operating profit by the amount of investment it took to get that profit:
ROIC = net operating profit after taxes / invested capital
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 lands between 8% and 12%. Ideally, we want to see ROIC greater than 12%, at minimum. We're also seeking a history of increasing returns, or at least steady returns -- an indication that the company's moat can withstand competitors' assaults.
Let's look at the ROIC figures over several time periods for Mattel
|
Company |
Trailing 12 Months |
1 Year Ago |
3 Years Ago |
5 Years Ago |
|---|---|---|---|---|
|
Mattel |
23.1% |
13.8% |
18.9% |
18.5% |
|
Hasbro |
19.1% |
13.8% |
16.0% |
12.5% |
|
JAKKS Pacific |
5.0%* |
10.9%* |
11.5% |
13.1% |
Source: Capital IQ, a division of Standard & Poor's. *Uses 2007’s effective tax rate of 31.3%.
Mattel consistently exceeds our desired 12% ROIC, and it has grown its returns by more than 4 percentage points from five years ago. Like Mattel, Hasbro’s ROIC took a dip last year, but both have since recovered. Hasbro also meets our 12% threshold for attractiveness and has grown its returns from five years ago. JAKKS Pacific appears less fortunate, having seen substantial downticks in ROIC for each period in the table. So while Hasbro and Mattel appear to have strengthened their positions from a half-decade ago, JAKKS looks weaker.
Businesses with consistently high ROIC are efficiently using capital. They can use their extra returns to buy back shares, further invest in their future success, or pay dividends to shareholders. (Warren Buffett especially likes that last part.)
To unearth more successful investments, dig a little deeper than the earnings headlines and check up on your companies' ROIC.
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