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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.
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 - Analyst Report)
12-month ROIC: 44.0%
5-year average ROIC: 33.6%
Forward P/E: 13.9
Varian Medical (VAR - Analyst Report)
12-month ROIC: 29.7%
5-year average ROIC: 28.6%
Forward P/E: 16.8
Dollar Tree Inc (DLTR - Analyst Report)
12-month ROIC: 32.5%
5-year average ROIC: 22.5%
Forward P/E: 16.6
Nu Skin Enterprises (NUS - Snapshot Report)
12-month ROIC: 29.3%
5-year average ROIC: 21.1%
Forward P/E: 13.5
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).