Warren Buffett's "moat" metaphor is well-known and widely accepted: If your company's business is the castle, its competitive position and ability to keep competitors at bay make up the moat around the castle. If the moat is wide, deep, and guarded by Monty Python's Black Knight, your company can prosper for a long time and it should trade at a premium to other companies. If the moat looks more like a melted ice cube, well, prepare for the plundering and pillaging of your company's profits. (Most companies have ice-cube moats or none at all.)

The problem with the moat metaphor is that it isn't easily quantifiable. The best way to translate evidence of a moat into numbers is to analyze returns on invested capital (ROIC). If ROIC is higher than the cost of acquiring that capital, your company is earning excess returns that can be put to all sorts of good uses: dividends, buybacks, reinvestment, etc.

Avoid shrinkage
Many investors believe growth is the defining characteristic of a potential investment -- but growth that doesn't earn high returns actually shrinks the value of the company! Only profitable growth increases the value of a firm. On top of that, some ROIC figures are more the result of a sorcerer's spell than of solid business performance. So to find investments that will make us rich over time, we need to ask the following three questions about returns:

  1. Over time, has the company earned a sufficiently high ROIC?
  2. Is the ROIC of high quality?
  3. Is the company maintaining and growing the returns it earns on invested capital?

To help you out, I've created a proprietary moat report card, which seeks to answer these questions by analyzing a company's financial statements. It's not intended to be a Magic 8-Ball, but it will hopefully get you pointed in the right direction.

With that in mind, let's take a look at Home Depot's (NYSE: HD) returns on capital and assess its moat.

ROIC history
Strong returns on capital are a sign of a potential moat, and a company's ability to earn excess returns over the long haul opens the drawbridge of profits. We like to see returns over 10% and it's even better if they outpace the returns competitors earn.

Let's see how Home Depot's three-year rolling ROIC has changed over time and in relation to its nearest competitor: Lowe's (NYSE: LOW):

Metric

2007

2008

2009

5-Year Average

Home Depot's rolling ROIC

16.7%

14.1%

12.9%

16.2%

Lowe's rolling ROIC

15.3%

13.1%

10.6%

14.1%

Data from Capital IQ, a division of Standard & Poor's.

While Home Depot has seen its ROIC decline over the past five years it has continued to earn well in excess of its cost of capital. Lowe's, as well as Sears Holdings (Nasdaq: SHLD), has suffered the same fate -- consistently declining ROIC -- as consumers spend less on home repair and related trinkets. Digging deeper, we see that Home Depot has dramatically slowed its domestic store openings and is spending its cash on a new distribution center to improve inventory practices.

While the verdict is still out on how profitable this and the other projects of CEO Frank Blake will be, we do know that Home Depot remains the industry leader with more than 2,200 stores.

Because only profitable returns add value to the firm, we assign a 30% weighting to consistently earning more than a 10% cost of capital hurdle and 20% to surpassing its competition. With consistently high returns that exceed those of its closest competitor, Home Depot scores well in the ROIC history category: 10 out of 10 points.

ROIC quality
Just like return on equity, there are only so many ways a firm can juice its ROIC. The three levers are profit margins, asset turnover, and leverage. Here are the data for Home Depot:

Metric

2007

2008

2009

5-Year Average

After-tax operating profit margin

6.0%

4.8%

4.9%

6.1%

Asset turnover

1.76

1.75

1.68

1.70

Operating ROA

10.5%

8.4%

8.3%

10.3%

ROA contribution to ROIC

70.0%

70.6%

70.1%

70.0%

         

Leverage

1.43

1.42

1.43

1.43

         

HD's ROIC with industry leverage

17.6%

13.7%

13.5%

17.1%

Industry ROIC

12.2%

8.6%

9.2%

12.2%

Data from Capital IQ, a division of Standard & Poor's.
ROA = return on assets.

Of the three factors that determine ROIC, improving profit margins and increasing asset turnover represent fundamental business improvement. The third factor, leverage, can have a major impact on ROIC but represents a financing decision rather than solid business execution. For that reason, we love to see companies improving their returns on capital by increasing profit margins and becoming more efficient -- this plays out in a company's operating return on assets (ROA). We think ROIC quality boils down to the contribution of ROA relative to the contribution of leverage.

Although Home Depot has seen profit margins dip, its results have been consistent with those of its industry. Over a longer time horizon the company has shown the ability to consistently achieve 6% after-tax operating margins. The company hopes that its new focus on customer service will have its customers buying more and shopping more often, which should help improve asset turnover, given improved inventory controls. Conservative in nature, Home Depot uses less leverage than its industry. If the company were to match the industry's use of leverage it could likely earn even higher returns on invested capital.

ROIC growth
The bigger the castle, the harder competitors will try to storm the gates. Companies that can improve their ROIC over time and relative to their competitors are likely widening their moat. We check to see that a firm is at least maintaining -- but hopefully growing -- ROIC over time and relative to invaders. This category accounts for the remaining 30% of the grade.

Metric

5-Year Average

Score

Weight

Average 3-year ROIC growth

(7.5%)

3

10%

Ratio of Home Depot's ROIC growth to Lowe's

1.2

4

20%

Data from Capital IQ, a division of Standard & Poor's.

As we noted above, Home Depot's weakening margins have caused ROIC to contract. Making things worse, the decline in returns has been steeper than the declines of Lowe's -- but not by much.

Given the fall of housing, the Great Recession, and declines in spending, this shouldn't be too surprising. Nevertheless, Home Depot has lost ground to its nearest competitor, and that fact is borne out in the table above.

Pencil's down!
With all the numbers in, here's how Home Depot scored:

 

Weighting

Category

Criteria

Final Grade

30%

Hurdle

3-year average ROIC > 10% hurdle rate

5

20%

 

3- year average ROIC > competitor's ROIC

5

20%

Quality

High ROA contribution percentage

5

10%

Growth

Rolling ROIC growth over time

3

20%

 

ROIC growth > competitor's ROIC growth

4

   

Total Score (out of 5)

4.7

   

Final Grade

A

With the most store locations, a great distribution network, and a renewed focus on customer service we shouldn't be surprised that Home Depot scores an A and has a strong moat.

The company has continued to earn high returns on capital even through recent consumer spending pullbacks and increased competition. While the orange apron has represented a strong brand and economic moat in the past, it doesn't automatically translate into high returns in the future. Prove that moat is enduring, buy at a reasonable valuation, and you're portfolio will stand a better chance of surviving the scratches and flesh wounds that the market dishes out.