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 PG&E (NYSE: PCG) 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

PG&E

4.4%

5.0%

5.1%

4.9%

Edison International (NYSE: EIX)

4.2%

4.9%*

5.8%

6.2%

Sempra Energy (NYSE: SRE)

4.0%

4.1%

6.1%

7.6%

Source: Capital IQ, a division of Standard & Poor's.
*Uses 2008’s effective tax rate of 30.7%.       

With utilities requiring substantial amounts of reinvestment each year, it's not surprising that ROIC is quite low. The returns here indicate as much, but these companies reward investors with nice dividend yields in place of capital appreciation. More concerning, however, is the consistent decline in ROIC that each of these companies has seen from five years ago. None of these companies passes our test.

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 owns none of the companies mentioned. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.