Return on invested capital is one of my very favorite metrics. In this article, I'll show how you can use it to find stocks to buy, stocks to watch, and stocks to avoid, starting with Pfizer (NYSE: PFE), and discussing competitors Merck (NYSE: MRK), GlaxoSmithKline (NYSE: GSK), Roche (OTC: RHHBY.PK), and Novartis (NYSE: NVS).

Beware ROE
You've probably heard of return on equity, a favorite of Warren Buffett. It measures net income (the "return") relative to the equity capital a business has raised and built. A higher ROE signals a more efficient business.

But ROE can be gamed. Because debt is cheaper than equity financing, a management team whose bonuses depend on ROE targets may be tempted to lever up, increasing risk, just to juice net income and ROE.

Return on invested capital -- which is like a return on debt and equity -- catches this. ("RODE" would have been a catchy acronym, no?) To find ROIC, simply divide a company's after-tax operating profit by the sum of its debt and equity. Because it includes debt, ROIC is harder to fudge than ROE. Studies also indicate that watching ROIC can improve your returns.

Why ROIC reigns supreme
Michael Mauboussin -- the chief smart dude at Legg Mason Capital Management -- divided stocks into quintiles by ROIC in 1997, then tracked them through 2006. The lowest 1997 quintile ended up performing worst, unsurprisingly. But the stocks with the highest starting ROIC didn't perform the best, with annual returns of less than 6%, mainly because they fell out of the top quintile along the way.

Two investing secrets emerge from the nuances of Mauboussin's findings:

1. If you find a rising ROIC, you could have a winner.
Companies that started 1997 in the lowest or second-lowest ROIC buckets, but finished 2006 in the highest or second-highest, delivered returns of 14% annually.

2. While a high ROIC alone doesn't help, consistently high ROIC is a marker of outperformance.
Companies that started in the No. 1 or No. 2 quintile in 1997, and remained there through 2006, delivered a whopping 11% annually.

Will our next contestant come on down?
Let's see how Pfizer, one of the world's largest drugmakers, stacks up by this measurement. We'll be using numbers from Capital IQ (a division of Standard & Poor's). For most moderate-risk companies, I consider anything greater than 9% to be a decent ROIC; over 12% is even better. The higher the risk, the higher the ROIC you'll need to be content.

ROIC for Pfizer





2010 (through June)






What can we conclude? Pfizer's returns aren't the highest, but they're steady and almost certainly above the company's own cost of capital. Good, in other words.

Of course, Pfizer isn't the only Big Pharma in town. Merck's ROIC hovered around and just under 15% over the same time frame, until 2009, when the Schering-Plough acquisition threw a wrench into Merck's financials. Still if Merck can work through the integration costs to return the company to its former glory, investors should be well served. British GlaxoSmithKline is the ROIC king of the group: The 18% it earned over the past 12 months is actually the lowest figure in the past five years, where percentages in the mid-20s to over 30% ROIC were common. As a side note, Glaxo is unlevering a bit after reaching a recent peak in 2008, so its ROE is falling as we'd expect. Novartis, a 5-star Motley Fool CAPS stock, is even steadier than Pfizer, with numbers right around 10% for every year surveyed. And finally, Roche is the only pharma whose ROIC has risen notably: from 12.5% in 2006 to over 20% in the last 12 months, thanks to its recent Genentech merger.

In the end, remember that ROIC is still a rearward looking measure. Pfizer and all the big pharmas still have to contend with sky-high drug development costs, declining marginal returns on research and development spending for chemical-based drugs, and ongoing (I'd argue) uncertainty about health-care reimbursement globally. Pfizer's stock is down about 20% over the past five years, not including dividends. For some investors, that might be enough to price the bad news into this steady ROIC performer.

For still more Foolishness:

Interested in Pfizer? Add it to your watchlist. Or click on the companies to add Merck, GlaxoSmithKline, Novartis, or Roche.

James Early owns no stocks mentioned in this article. You can investigate his Motley Fool Income Investor newsletter free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.