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 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 Weyerhaeuser (NYS: WY) and three of its industry peers, to see how efficiently they use cash. Here are the ROIC figures for each company over a few periods.

Company

TTM

1 year ago

3 years ago

5 years ago

Weyerhaeuser 3.2%* (0.6%)* 0.2%* 4.8%
Temple-Inland (NYS: TIN) 2.8%** 1.7% 2.0% 1.3%
Plum Creek Timber (NYS: PCL) 6.6% 5.7%*** 9.5%*** 10.1%
International Paper (NYS: IP) 8.4% 4.5% 6.1% 3.1%****

Source: Capital IQ, a division of Standard & Poor's.
* Because WY did not report an effective tax rate, we used its 36.2% effective tax rate from five years ago.
** Because TIN did not report an effective tax rate, we used its 37% effective tax rate from one year ago.
*** Because PCL did not report an effective tax rate, we used its 2% effective tax rate from five years ago.
**** Because IP did not report an effective tax rate, we used its 26% effective tax rate from three years ago.

Weyerhaeuser's returns have declined from five years ago, suggesting that its competitive position is growing weaker. Plum Creek has also seen declines in its returns on invested capital, while the other two listed companies have increased their ROIC. The lack of effective tax rates for various periods also affects the comparability of results over time.

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.

At the time this article was published Jim Royal, Ph.D., owns shares of Plum Creek. The Fool owns shares of and has written puts on Plum Creek Timber. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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. 

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

What is Short Selling?

Make a profit when stocks prices fall.

View Course »

Introduction to Preferred Shares

Learn the difference between preferred and common shares.

View Course »

Add a Comment

*0 / 3000 Character Maximum