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 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 put, 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
(We've got more details about this formula, if you're curious.)
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 efficiently the company uses capital.
Ultimately, we're looking for companies that can invest their money at rates higher than the cost of capital, which for most businesses lands between 8% and 12%. Ideally, we want to see ROIC exceeding 12% at minimum, coupled with a history of steady or increasing returns, which indicate some durability to the company's economic moat.
Let's take a look at Activision Blizzard
1 year ago
3 years ago
5 years ago
Take-Two Interactive Software
Source: Capital IQ, a division of Standard & Poor's.
*Because Activision did not report an effective tax rate, we used its 18% rate from TTM.
**Because Electronic Arts did not report an effective tax rate, we used its 38% rate from five years ago.
***Because Take-Two did not report an effective tax rate, we used its 15.4% rate from this year.
Activision Blizzard's returns on invested capital are down dramatically from three and five years ago, suggesting that its competitive position has become weaker. Take-Two's ROIC is up significantly over that time period, while Electronic Arts is back into the negatives. Sony is floating around breakeven ROIC.
Businesses with consistently high ROIC can prove 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. Warren Buffett has long loved healthy and growing dividends -- and you should, too.
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. owns shares of Activision Blizzard. The Motley Fool owns shares of Take-Two Interactive Software and Activision Blizzard. The Fool has opened a short position on Activision Blizzard. Motley Fool newsletter services have recommended buying shares of Activision Blizzard and Take-Two Interactive Software. Motley Fool newsletter services have recommended creating a synthetic long position in Activision Blizzard. 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.
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