We'd all like to invest like the legendary Warren Buffett, watching our initial thousands of dollars multiply into millions or more. Buffett analyzes companies by calculating return on invested capital (ROIC) in order to help determine whether a company can earn more from its money than it cost to make that money in the first place.
ROIC may be value investing's most important metric. 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, ROIC divides a company's operating profit by how much investment it took to get that profit:
ROIC = Net operating profit after taxes / Invested capital
If you need it, here's a more detailed explanation. This one-size-fits-all calculation eliminates excessive debt and many of the other legal accounting tricks 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 exceeding their cost of capital, which for most businesses lands between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum. We also seek a history of increasing, or at least steady, returns, which indicate some durability to the company's economic moat.
Let's take a look at Lockheed Martin
|
Company |
TTM |
1 year ago |
3 years ago |
5 years ago |
|---|---|---|---|---|
| Lockheed Martin | 13.1% | 13.5% | 18.4% | 11.2% |
|
Northrop Grumman |
12% | 8.6% | 7.5% | 5.7% |
|
Raytheon |
13.3% | 13.3% | 11.4% | 6.1% |
Source: Capital IQ, a division of Standard & Poor's.
Each of these three companies meets our 12% threshold for attractiveness -- though Northrop just barely squeaks by. Northrop has shown steady improvement across the last five years, as has Raytheon, suggesting improvement in their competitive positions. Lockheed has declined from three years ago, but it remains solidly above its 11.2% figure from five years ago.
Businesses with consistently high ROIC prove that they're efficiently using capital. They also have the ability to treat shareholders well, because they can use their extra cash to pay dividends, buy back shares, or further invest in their franchises. And anyone who knows Warren Buffett knows he loves healthy and growing dividends.
To find more successful investments, dig deeper than the earnings headlines, and unearth the company's ROIC. If you'd like to add these companies to your watchlist, or set up a new one, just click here .