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, 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 look at Delta Air Lines
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 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
(Read more 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 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 Delta and three of its industry peers over a few periods.
Source: S&P Capital IQ.
TTM=trailing 12 months.
*Because Delta Air Lines did not report an effective tax rate, we used its 2.4% rate from one year ago.
**Because Southwest did not report an effective tax rate, we used its 36% rate from three years ago.
***Because United Continental did not report an effective tax rate, we used its 0.6% rate from TTM.
****Because Alaska Air Group did not report an effective tax rate, we used its 38% rate from one year ago.
United Continental Holdings and Alaska Air Group both have returns on invested capital in the 11% range. Both also saw their ROIC dip into the negative numbers three years ago, and then grow steadily and dramatically since then. Delta Air Lines saw its ROIC spike to 8.6% last year and then decline by more than a percentage point since then. Southwest has the lowest returns on invested capital of these companies; its returns have fluctuated a great deal over the five-year period, and its current returns are substantially lower than they were five years ago.
Delta suffered a great deal from the economic recession because consumers lacked the spending money to travel and companies were trying to find ways to cut back on business travel. In addition, Delta had to deal with increased expenses from rising fuel prices. The company survived by adding fees for a variety of services that were previously complimentary, including baggage and food. It also added fuel surcharges and raised airfares to help cover its expenses. While this approach helped Delta make it through hard times in the past, it continues to face the threat of rising fuel prices and will need to find a way to face these fundamental challenges facing airlines, including United Continental, Alaska Air, and Southwest, to be successful in the long term.
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. Motley Fool newsletter services have recommended buying shares of Southwest Airlines. 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.