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
(We have more details on 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 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 Compass Diversified Holdings
1 Year Ago
3 Years Ago
5 Years Ago
|Compass Diversified Holdings||6.4%*||2.4%*||1.5%||1.8%*|
Automatic Data Processing
Source: Capital IQ, a division of Standard & Poor's.
*Because CODI did not report an effective tax rate, we used a 35% rate.
**Because DDIC did not report an effective tax rate for five years ago, we used its 32% effective tax rate from three years ago.
Compass Diversified Holdings has consistently grown its returns over the past three years, suggesting that its competitive position is growing stronger. DDI has also increased its returns on invested capital over the past half-decade. Automatic Data Processing is down from its highs but still solidly above five years ago, while Paychex leads this group with a very strong return on invested capital, even though it's down from three years ago.
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. Warren Buffett has long loved healthy and growing dividends -- and you should, too.
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 of any company mentioned here. Motley Fool newsletter services have recommended buying shares of Paychex and Automatic Data Processing. 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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