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) in order 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, it divides a company's operating profit by how much investment it took to get that profit:

ROIC = Net operating profit after taxes / Invested capital

The nuances of the formula are explained in further detail here. 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 provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficient 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%. Ideally, we want to see ROIC exceeding 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Let's take a look at CVS Caremark (NYSE: CVS) and two of its industry peers, to see how efficiently they use cash. Here are the ROIC figures for each company over a few periods.



1 year ago

3 years ago

5 years ago

CVS Caremark 7.4% 8% 6.8% 6.2%
Walgreen (NYSE: WAG) 14.1% 14.5% 15% 16.8%
Rite Aid (NYSE: RAD) 2.6%* 2.5%* 1.9%* 7.1%*
Wal-Mart Stores (NYSE: WMT) 14.3% 14.8% 13.2% 13.6%

Source: Capital IQ, a division of Standard & Poor's.
*Assumes 30% tax rate for comparison purposes.

CVS has shown figures that consistently trail those of key rival Walgreen, suggesting that its competitive positioning is not as good. Still, Walgreen's ROIC has steadily declined over the last five years. Rite Aid hovers at more than 0% for the last few years, and I had to assume a 30% tax rate for the calculations to make sense, given that a string of losses have left the company with no effective tax rate. Wal-Mart shows a history of steady ROIC, although last year's fell a bit from the year before. Wal-Mart's steady numbers suggest that its competitive position remains solid.

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 us dividends, 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 to add these companies to your Watchlist or set up a new Watchlist, just click here .

Jim Royal, Ph.D., does not own shares of any company mentioned. Wal-Mart is a Motley Fool Inside Value recommendation. Wal-Mart is a Motley Fool Global Gains pick. Wal-Mart is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Wal-Mart. The Fool owns shares of Wal-Mart. Try any of our Foolish newsletter services 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.