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 Eaton (NYSE: ETN) 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

Eaton

8.9%*

4.9%*

11.9%

12.6%

ITT (NYSE: ITT)

12.1%

13.1%

14.3%

9.8%

Parker Hannifin (NYSE: PH)

9%

8.1%

13.6%

11.4%

Source: Capital IQ, a division of Standard & Poor's. *Uses 2008's effective tax rate of 6.4%.
ITT just meets our 12% threshold over the past four quarters, but its ROIC has declined from three years ago. Still, it is up from a half-decade ago. Parker Hannifin also shows declines in its ROIC, and it fails to meet our 12% threshold for attractiveness, and Eaton too is clearly down from three and five years ago. It should be noted that Eaton has been taxed at an abnormally low rate in the last few periods listed here, a fact that helps boost these ROIC figures.

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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James Royal does not own any of the companies mentioned. ITT is a Motley Fool Inside Value pick. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.