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.
In this series, we examine several companies in a single industry to determine their ROIC. Let's take a look at Frontier Communications
Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's 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
(You can get further details on 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 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.
Here are the ROIC figures for Frontier and three industry peers over a few periods.
1 Year Ago
3 Years Ago
5 Years Ago
Source: S&P Capital IQ. TTM=trailing 12 months.
*Because T did not report an effective tax rate for one year ago, we used its 35% effective tax rate from three years ago.
Frontier's returns on invested capital are less than half of what they were five years ago. The other companies have also seen declines in their ROIC from five years ago, suggesting that the telecom space is particularly difficult.
One thing that makes Frontier so attractive to investors is its high dividend yield. Unfortunately, its low returns, which are shrinking over time, suggest that Frontier may not be able to grow its dividend in the future. In fact, Frontier already had to decrease its dividend by 25% last year, and its shrinking ROIC suggests that it may have to reduce those yields even more.
On the upside, Frontier's acquisition of Verizon assets last year gives it the potential to take advantage of economies of scale, which could help it improve its returns on invested capital in the future. Its increase in returns from last year offers some hope in Frontier's ability to improve its ROIC to a more attractive level.
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. Feel free to add these companies to your Watchlist:
Jim Royal, Ph.D., owns shares of Frontier. 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.