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, it divides a company's operating profit by how much investment it took to get that profit. The formula is:
ROIC = Net operating profit after taxes / Invested capital
(You can read more about 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 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 above 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 SanDisk
1 Year Ago
3 Years Ago
5 Years Ago
Source: S&P Capital IQ.
*Because SNDK did not report an effective tax rate, we used its 22% rate from one year ago.
**Because STX did not report an effective tax rate, we used its 13% rate from TTM.
***Because WDC did not report an effective tax rate, we used its 8% rate from one year ago.
SanDisk's returns on invested capital are almost 3 percentage points higher than they were five years ago but have declined since last year. Two of the other listed companies have seen more dramatic growth in their ROIC, while Western Digital has seen dramatic declines in its ROIC over the same time period.
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. Add these companies to your Watchlist:
Jim Royal, Ph.D., owns no shares of any company mentioned here. The Motley Fool owns shares of Western Digital. 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.