We'd all like to invest as successfully as the legendary Warren Buffett. 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 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 DuPont (NYSE: DD ) 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
|
|
DuPont
|
11.4%
|
6.1%
|
13.3%
|
10.5%
|
|
Ashland (NYSE: ASH )
|
5.8%
|
-1.7%
|
5.3%
|
4.1%*
|
|
Dow Chemical (NYSE: DOW )
|
3.9%
|
1.6%**
|
9.2%
|
11.6%
|
Source: Capital IQ, a division of Standard & Poor's. *Assumes 2004 tax rate of 24%. **Assumes 2005 tax rate of 27.8%.
DuPont almost meets our desired 12% return on invested capital, but its ROIC has fluctuated a great deal in the past five years. Ashland offers us lower ROIC, and also gives us fluctuating returns over time. Nothing attractive there. Dow looks even less desirable over the past four quarters, but has displayed consistently decreasing returns on capital over the last half-decade, indicating perhaps an eroding moat. The question investors should ask is: Can Dow and DuPont consistently return to their former selves?
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. (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.
The Motley Fool is buying 50 stocks in 50 days for its real-money "11 O'Clock Stock" series. For more information, click here. Then come back to Fool.com every single weekday at 11 a.m. ET for a brand-new pick!
RSS Headlines
Fool UK