In his Annual Letter to Shareholders in 1992, legendary investor
Warren Buffett stated the following:
"Leaving the question of price aside, the best business to own
is one that over an extended period can employ large amounts of
incremental capital at very high rates of return. The worst
business to own is one that must, or will, do the opposite - that
is, consistently employ ever-greater amounts of capital at very low
rates of return."
So how do you know how well a company is employing its capital?
Look at its Return on Invested Capital.
ROIC Defined
Return on Invested Capital (ROIC) is calculated as:
Net Operating Profit After Taxes / Invested Capital
Invested capital is broken down further as
Total Assets - Excess Cash - Non-Interest-Bearing Current
Liabilities.
An ROIC of 15% means that for every $1 of capital invested in a
business, 15 cents of after-tax income was created during that
period. The best companies generate returns above their weighted
average cost of capital (WACC).
The weighted average cost of capital is the minimum return required
to satisfy all investors, including creditors and shareholders.
Companies with ROIC greater than their WACC are creating value for
their owners. They are earning superior risk-adjusted returns for
investors and generating positive economic profits.
On the other hand, companies with ROIC below their cost of capital
are destroying value for shareholders. They are earning returns
below what the market requires for assuming the risk of investing
in the company.
EPS Growth Does Not Equal Value Creation
It is important to note that just because a company is growing its
earnings per share doesn't mean that the growth is profitable.
Assume a company dumps $1 billion of capital into a project that
generates $50 million of earnings next year. Sure earnings grew,
but it produced a return of just 5%. That $1 billion in capital
would have been better used elsewhere.
Conversely, if the company can generate $50 million in earnings
from an investment of, say, $250 million, that's a much better 20%
return.
Protect the Castle
If a company or an entire industry is consistently generating
returns well above its cost of capital, you can be sure that this
will attract some competition. Entrepreneurs will seek to enter the
industry in an attempt to capture some of the outsized returns.
In order to fend off this competition and sustain positive economic
profits, a company needs to have some sort of durable competitive
advantage, or "moat".
Competitive advantages can come in many different forms, most of
which fall into two different categories: cost advantage and
differentiation advantage.
The cost advantage is a company's ability to produce a good or
service at a lower cost than the competition. Think
Wal-Mart
(
WMT
).
The differentiation advantage is created when a company's products
or services are perceived as superior by customers. Think
Apple
(
AAPL
).
The wider a company's "moat", the more effective it will be at
fighting off competitors.
One of the best ways to determine a company's moat is to measure
its Return on Invested Capital. A true wide moat business will have
stable or growing ROIC.
Profitable Growth at a Reasonable Price
The problem for many value investors is that companies with
sustainable competitive advantages often trade at premiums to the
market. Nevertheless, if you look hard enough, there are some good
deals out there.
Here are 4 reasonably priced stocks with superior (and growing)
returns on invested capital:
Autozone Inc
(
AZO
)
12-month ROIC: 44.0%
5-year average ROIC: 33.6%
Forward P/E: 13.9
Varian Medical
(
VAR
)
12-month ROIC: 29.7%
5-year average ROIC: 28.6%
Forward P/E: 16.8
Dollar Tree Inc
(
DLTR
)
12-month ROIC: 32.5%
5-year average ROIC: 22.5%
Forward P/E: 16.6
Nu Skin Enterprises
(
NUS
)
12-month ROIC: 29.3%
5-year average ROIC: 21.1%
Forward P/E: 13.5
Conclusion
For the long-term value investor, return on invested capital is
perhaps the most important metric to consider. The best companies
to own are the ones that can consistently employ their capital at
high rates of return, not just the ones who grow EPS the fastest.
Before you invest your hard-earned money with a company, make sure
it is using its capital wisely.
Todd Bunton is the Growth & Income Stock Strategist for
Zacks Investment
Research
and Editor of the
Income Plus Investor service
.
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Disclosure: The author owns shares of Apple (AAPL).
AUTOZONE INC (AZO): Free Stock Analysis Report
AUTOZONE INC (AZO): Free Stock Analysis Report
DOLLAR TREE INC (DLTR): Free Stock Analysis
Report
DOLLAR TREE INC (DLTR): Free Stock Analysis
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NU SKIN ENTERP (NUS): Free Stock Analysis
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NU SKIN ENTERP (NUS): Free Stock Analysis
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VARIAN MEDICAL (VAR): Free Stock Analysis
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VARIAN MEDICAL (VAR): Free Stock Analysis
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