We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital (ROIC) to help determine whether a company has an economic moat -- the ability to earn returns on its money above 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, ROIC divides a company's operating profit by how much investment it took to get that profit. The formula:
ROIC = Net operating profit after taxes / Invested capital
(You can read more on the nuances of the formula.)
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 is between 8% and 12%. We prefer to see ROIC above 12% at a minimum, along with a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.
Let's look at Home Depot
1 Year Ago
3 Years Ago
5 Years Ago
Source: Capital IQ, a division of Standard & Poor's.
Home Depot's ROIC is down substantially from five years ago, but key rival Lowe's has seen the same trend, suggesting that there may be a macro trend affecting both. And it's hardly a surprise what the trend is" the major decline in housing. In normal times, both of these peers appear to comfortably exceed our 12% threshold for attractiveness, with Home Depot consistently beating its rival. Upstart Lumber Liquidators has shown even better ROIC, although it has fluctuated markedly from year to year.
Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.
So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. If you'd like, you can add these companies to your watchlist.
Jim Royal, Ph.D., owns no shares in any company mentioned. Home Depot and Lowe's are Motley Fool Inside Value picks. Lumber Liquidators is a Motley Fool Rule Breakers recommendation. Motley Fool Options has recommended writing covered calls on Lowe's. The Fool owns shares of Lumber Liquidators. 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.
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