Warren Buffett's "moat" metaphor is well-known and widely accepted: If your company's business is the castle, its competitive position and ability to keep competitors at bay make up the moat around the castle. If the moat is wide, deep and guarded by Monty Python's Black Knight, your company can prosper for a long time and it should trade at a premium to other companies. If the moat looks more like a melted ice cube, well, prepare for the plundering and pillaging of your company's profits. In fact, most companies have ice cube moats or none at all.

The problem with the moat metaphor is that it isn't easily quantifiable. The best way to translate evidence of a moat into numbers is to analyze returns on invested capital. If ROIC is higher than the cost of acquiring that capital, your company is earning excess returns that can be put to all sorts of good uses: dividends, buybacks, reinvestment, etc.

Avoid shrinkage
Many investors believe growth is the defining characteristic of a potential investment -- but growth that doesn't earn high returns actually shrinks the value of the company! Only profitable growth increases the value of a firm. On top of that, some ROICs are more the result of a sorcerer's spell than of solid business performance. So to find investments that will make us rich over time, we need to ask the following three questions about returns:

  1. Over time, has the company earned a sufficiently high ROIC?
  2. Is the ROIC of high quality?
  3. Is the company maintaining and growing the returns it earns on invested capital?

To help you out, I've created a proprietary moat report card, which seeks to answer these questions by analyzing a company's financial statements. It's not intended to be a Magic 8-Ball, but it will hopefully get you pointed in the right direction.

With that in mind, let's take a look at International Business Machine's (NYSE: IBM) returns on capital and assess its moat.

ROIC history
Strong returns on capital are a sign of a potential moat, and a company's ability to earn excess returns over the long haul opens the drawbridge of profits. We like to see returns more than 10%, and it's even better if they outpace the returns competitors earn.

Let's see how IBM's three-year rolling ROIC has changed over time and in relation to its nearest competitor: Hewlett-Packard (NYSE: HPQ):

 

2007

2008

2009

5-Year Avg.

IBM's rolling ROIC

20.1%

26.8%

32.4%

23.0%

Hewlett-Packard's rolling ROIC

17.7%

19.9%

19.6%

16.7%

Source: Capital IQ, a division of Standard & Poor's.

IBM has seemingly done a masterful job increasing the returns it earns on capital invested. Digging deeper, we see that part of this is due to a shift in business away from commodity computer hardware and toward specialized and value-added services and consulting.

Because only profitable returns add value to the firm, we assign a 30% weighting to consistently earning more than a 10% cost of capital hurdle and 20% to surpassing its competition. With consistently high returns that trump its closest competitor, IBM scores full credit in the ROIC history category: 10 out of 10 points.

ROIC quality
Just like return on equity, there are only so many ways a firm can juice its ROIC. The three levers are profit margins, asset turnover, and leverage. Here are the data for IBM:

 

2007

2008

2009

5-Year Avg.

After-tax operating profit margin

10.5%

12.7%

14.4%

11.2%

Asset turnover

0.94

1.07

0.99

0.99

Operating ROA

9.9%

13.6%

14.3%

11.1%

ROA contribution to ROIC

46.2%

35.8%

37.7%

42.3%

 

 

 

 

 

Leverage

2.16

2.79

2.65

2.39

 

 

 

 

 

IBM's ROIC with industry leverage

24.9%

33.2%

32.7%

26.8%

Industry ROIC

27.6%

27.2%

24.6%

25.8%

Source: Capital IQ, a division of Standard & Poor's.

Of the three factors that determine ROIC, improving profit margins and increasing asset turnover represent fundamental business improvement. The third lever, leverage, can have a major impact on ROIC but represents a financing decision rather than solid business execution. For that reason, we love to see companies improving their returns on capital by increasing profit margins and becoming more efficient -- this plays out in a company's operating return on assets. We think ROIC quality boils down to the contribution of ROA relative to the contribution of leverage.

IBM has seen a dramatic increase in its profit margins thanks to its higher-margin consulting and service business replacing lower-margin computer hardware business. While ROA has risen more than 14%, its contribution to ROIC has declined to 37.7%. Why? Just look at the leverage line; IBM has been adding debt to pad its returns. But since using leverage isn't bad on its own, we look at what ROIC would have been if IBM had used the leverage common to its industry and see that the company still performs well enough to score a 4 for ROIC quality.

ROIC growth
The bigger the castle, the harder competitors will try to storm the gates. Companies that can improve their ROIC over time and relative to their competitors are likely widening their moat. We check to see that a firm is at least maintaining -- but hopefully growing -- ROIC over time and relative to invaders. This category accounts for the remaining 30% of the grade.

 

5-Year Average

Score

Weight

Average rolling 3-year ROIC growth

16.8%

5

10%

ROIC growth vs. Hewlett-Packard

1.0

4

20%

Source: Capital IQ, a division of Standard and Poor's.

Not only has IBM achieved consistent growth in its ROIC, its growth rate has matched that of Hewlett-Packard -- indicating that it is not missing out on any industrywide investment opportunities. Compared to Oracle's (Nasdaq: ORCL) declining ROIC, it suggests that IBM is winning some battles in the software arena.

Pencils down!
With all the numbers in, here's how IBM scored:

Weighting

Category

Criteria

Final Grade

30%

Hurdle

3-year average ROIC > 10% hurdle rate

5

20%

 

3- year average ROIC > competitor's ROIC

5

20%

Quality

High ROA contribution percentage

4

10%

Growth

Rolling ROIC growth over time

5

20%

 

ROIC growth > competitor's ROIC growth

4

   

Total Score (out of 5)

4.6

   

Final Grade

A

An A is an admirable grade for a company in such a competitive industry. It appears IBM has enjoyed the protection of an economic moat in the past -- the key now is to determine whether the company will be able to retain its moat in the future. Prove that, buy at a reasonable valuation, and your portfolio will stand a better chance of surviving the scratches and flesh wounds that the market dishes out.

Bryan Hinmon does not own shares in any company mentioned in this article. The Motley Fool owns shares of Oracle. The Motley Fool has a disclosure policy.