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 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.
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, it divides a company's operating profit by how much investment it took to get that profit:
ROIC = Net operating profit after taxes / Invested capital
(We've got more details about this formula, if you're curious.)
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 higher than the cost of capital, which for most businesses lands between 8% and 12%. Ideally, we want to see ROIC exceeding 12% at minimum, coupled with a history of steady or increasing returns, which indicate some durability to the company's economic moat.
Let's take a look at Gap (NYSE: GPS ) and three of its industry peers, to see how efficiently they use cash. Here are the ROIC figures for each company over a few periods.
|
Company
|
TTM
|
1 Year Ago
|
3 Years Ago
|
5 Years Ago
|
| Gap |
32.9% |
35.3% |
23.1% |
26.2% |
| Limited Brands (NYSE: LTD ) |
22.1% |
15.4% |
10.8% |
17.5% |
| Polo Ralph Lauren (NYSE: RL ) |
18.9% |
18.3% |
14.1% |
15.0% |
| Aeropostale (NYSE: ARO ) |
60.3% |
97.1% |
48.3% |
42.3% |
Source: Capital IQ, a division of Standard & Poor's.
Gap has increased its returns on invested capital from five years ago, suggesting that its competitive position is growing stronger. Remarkably, all four of these companies have increased their returns over the same period.
Businesses with consistently high ROIC can prove 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 us dividends, buy back shares, or further invest in their franchise. Warren Buffett has long loved healthy and growing dividends -- and you should, too.
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 or set up a new watchlist, just click here.
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