We'd all like to invest as successfully as the legendary Warren Buffett does. 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 it 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 -- an indication that the company's moat can withstand competitors' assaults.

Let's look at the ROIC figures over several time periods for Mead Johnson Nutrition (NYSE: MJN) and two of its industry peers to see how efficiently they use capital.

Company

Trailing 12 Months

1 Year Ago

3 Years Ago

5 Years Ago

Mead Johnson

70.7%

91.6%

54.4%*

NA

J.M. Smucker (NYSE: SJM)

7.9%

5.8%

7.1%

7.1%

Herbalife (NYSE: HLF)

42.5%

32.3%

35.6%

6.3%

Source: Capital IQ, a division of Standard & Poor's.
*For fiscal 2007.    
                                           

Mead Johnson has shown remarkable levels of ROIC for the past few years, but it's been publicly traded for less than two years. The decline from last year should be of little concern, given the high absolute level of returns and the understanding that such initial returns are abnormal. Herbalife also easily surpasses our 12% threshold for attractiveness, and better still, it shows an uptrend from five years ago, an indication that the company is strengthening its competitive position. In contrast, Smucker offers stagnant ROICs, which at least don't seem to be significantly declining.

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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Jim Royal, Ph.D., owns no shares in any company mentioned. 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 Motley Fool has a disclosure policy.