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) 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, 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 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 Central European Distribution
|
Company |
TTM |
1 Year Ago |
3 Years Ago |
5 Years Ago |
|---|---|---|---|---|
| Central European Distribution | 2.5%* | 4.5% | 5.9% | 6.2% |
|
AMBEV |
28.9% | 24.3% | 15.4% | 9.9% |
|
Molson Coors Brewing |
3.4% | 3.2%** | 5.7%** | 5.0% |
|
Boston Beer |
32.6% | 24.7% | 22.8% | 34.9% |
Source: Capital IQ, a division of Standard & Poor's. TTM = trailing 12 months.
* Because Central European Distribution did not report an effective tax rate for TTM, we used its 18.1% effective tax rate from one year ago.
**Because Molson Coors did not report an effective tax rate last year or three years ago, we used its 18.5% effective tax rate from five years ago.
Central European Distribution's returns on invested capital have declined over the past five years, suggesting its competitive position is eroding. In contrast, AMBEV has seen some big improvements in its returns over the same time period. The other two companies have seen slight declines on their returns from 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 or set up a new Watchlist, just click here.
