We'd all like to invest as successfully as the legendary Warren Buffett. He calculates return on invested capital 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 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, which indicate that the company's moat can withstand competitors' assaults.
Let's look at Gap (NYSE: GPS ) and two of its industry peers to see how efficiently they use capital. Here are the ROIC figures for each company over several time periods:
|
Company
|
TTM
|
1 year ago
|
3 years ago
|
5 years ago
|
|
Gap
|
33.5%
|
25.8%
|
17.9%
|
27.9%
|
|
Limited Brands (NYSE: LTD )
|
15.4%*
|
6.4%
|
12.9%
|
16.0%
|
|
Polo Ralph Lauren (NYSE: RL )
|
20.0%
|
17.0%
|
15.4%
|
18.5%
|
Source: Capital IQ, a division of Standard & Poor's. *For the period ending May 2010.
Gap offers us very high returns, especially for a retail store, and over the past three years it has given us the kind of steady growth in its return on invested capital that we like to see, suggesting the company is tightening up its operations. Polo Ralph Lauren also offers high returns on capital and has also shown growth over the past three years. Limited Brands, on the other hand, is down slightly over the last half-decade. Still, each of these companies compares very favorably to the blue chips of retail.
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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