The investment world is full of ratios and metrics that you can use to evaluate a company. The trick is in figuring out which ones are the most useful. For clues, we often look to the investing titans, to see what numbers they examine. One measure that Berkshire Hathaway's Warren Buffett likes to look at is return on invested capital.
When discussing how he reviews the companies he owns, he explained in his 1987 letter to shareholders that although he can look at operating earnings, that figure "says nothing about economic performance." He continued: "To evaluate that, we must know how much total capital -- debt and equity -- was needed to produce these earnings."
A high ROIC can help you zero in on effective management. If you don't like companies keeping a lot of cash sitting around in this low-interest rate environment, the ROIC doesn't like that, either: Unproductive cash will drag the metric down. A healthy ROIC will reveal a management that's putting its money to good use and generating solid profits for shareholders.
At his 1998 shareholder meeting, Buffett reportedly said: "If you have a business that's earning 20% to 25% on capital, time is your friend. But time is your enemy if your money is in a low-return business." There are plenty of companies with those kinds of numbers.
For example, Chinese Internet search giant Baidu
Other high-ROIC companies include priceline.com (38%) and Ctrip (26%).
Many investors like to look at a company's return on equity, since it's easy to calculate and easy to find online. Baidu, priceline.com, and Ctrip all sport high ROE figures in addition to their high ROIC. But a closer look points out a flaw in ROE: It can be inflated if a company uses debt financing.
No measurement is perfect, of course. Even ROIC, which uses earnings in its formula, doesn't show where they're coming from -- from operations, for example, versus from sales of assets or currency translation effects.
Your best bet is to consider adding ROIC to your arsenal of tools, but to also keep learning about investing, because knowing a few ratios is never enough. There are lots of great companies and great stock bargains out there, and the more you know, the more effective you'll be at finding the gems and doing well.
What are the measures you examine most often when you study stocks? Let us know -- leave a comment below!
Here are some stocks Rich Greifner thinks Buffett wishes he could buy.
Longtime Fool contributor Selena Maranjian owns shares of Netflix and Berkshire Hathaway. Baidu is a Motley Fool Rule Breakers choice. Berkshire Hathaway, Netflix, and priceline.com are Motley Fool Stock Advisor selections. Ctrip.com International is a Motley Fool Hidden Gems selection. The Fool owns shares of Berkshire Hathaway, which is also a Motley Fool Inside Value pick. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.