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 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, which indicate that the company's moat can withstand competitors' assaults.

Let's look at Wal-Mart (NYSE: WMT) 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.



1 Year Ago

3 Years Ago

5 Years Ago

Wal-Mart 14.3%




Costco (Nasdaq: COST) 15.2%




Target (NYSE: TGT) 10.6%




Source: Capital IQ, a division of Standard & Poor's. Uses the TTM effective tax rate of 38%.         

Wal-Mart and Costco have both surpassed our 12% threshold for returns on invested capital, but Wal-Mart's returns are down from last year and five years ago. Target has failed to offer us the returns we're looking for and sits pretty consistently in the 10%-11% band for ROIC. You can see that retail is tough when world-class operations like these achieve acceptable but not stellar returns on invested capital.

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.

Jim Royal, Ph.D., owns no shares in any company mentioned here. The Motley Fool owns shares of Costco and Wal-Mart, which are both Motley Fool Inside Value selections. Costco is also a Motley Fool Stock Advisor recommendation Wal-Mart is a Motley Fool Global Gains pick. Motley Fool Options has recommended a diagonal call position on Wal-Mart. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.