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, or 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 put, 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
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 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%. 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 Weyerhaeuser
1 Year Ago
3 Years Ago
5 Years Ago
Plum Creek Timber
Source: S&P Capital IQ. TTM = trailing 12 months.
* Because Weyerhaeuser did not report an effective tax rate, we used its 23.3% rate from five years ago.
** Because Temple-Inland did not report an effective tax rate, we used its 33.3% rate from the trailing 12 months.
*** Because Plum Creek Timber did not report an effective tax rate, we used a 35% rate.
**** Because International Paper did not report an effective tax rate, we used its 29.3% rate from three years ago.
Weyerhaeuser's returns on invested capital are lower than they were five years ago, but they have consistently increased over the past three years. Plum Creek's ROIC is also lower than it was five years ago, while Temple-Inland has seen slight increases in its returns, and International Paper's ROIC is more than double what it was five 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. 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, click below:
Jim Royal, Ph.D., owns shares of Plum Creek. The Motley Fool owns shares of Weyerhaeuser and Plum Creek Timber. 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.