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 CME Group
|
Company |
TTM |
1 year ago |
3 years ago |
5 years ago |
|---|---|---|---|---|
|
CME Group |
3.3% |
3.0% |
14.7% |
14.3% |
|
NYSE Euronext |
6.3% |
5.6%* |
2.7% |
20.9% |
|
Nasdaq OMX Group |
6.0% |
6.0% |
19.2% |
11.5% |
Source: Capital IQ, a division of Standard & Poor's. *Uses 2007’s tax rate.
Each of the companies listed here has shown a substantial decline in ROIC over the last half-decade, indicating that competition is eroding the returns for industry participants. In fact, a number of new competitors have been entering this space, and this ROIC helps show their effects. This situation looks particularly unattractive, and I’d like to investigate how these companies might solidify their ROIC.
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. (Warren 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.
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