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 (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.
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, 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 efficient 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.
Let's take a look at AT&T (NYSE: T) 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.
1 Year Ago
3 Years Ago
5 Years Ago
|Verizon Communications (NYSE: VZ)||8.5%||7.0%||7.7%||6.2%|
|Vodafone (Nasdaq: VOD)||4.4%||5.0%||5.0%||4.7%**|
|Frontier Communications (NYSE: FTR)||3.6%||6.7%||6.7%||7.6%|
Source: Capital IQ, a division of Standard & Poor's.
*Because AT&T did not report an effective tax rate this year, we used its 37.8% effective tax rate from last year.
**Because VOD did not report an effective tax rate five years ago, we used its 25% effective tax rate from three years ago.
AT&T saw decreased returns on invested capital from five years ago, suggesting that its competitive position is weaker. Of the companies listed above, only Verizon has improved its returns on invested capital from five years ago. It should also be noted that AT&T's effective tax rates are substantially higher than Verizon's, leading to much of the disparity in the ROICs of these two telecom giants.
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 or set up a new Watchlist, just click here.
Jim Royal, Ph.D., owns shares of Frontier and Vodafone. Motley Fool newsletter services have recommended buying shares of Vodafone and AT&T. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.