"A truly great business must have an enduring "moat" that protects excellent returns on invested capital." - Warren Buffett, 2007 Shareholder Letter
Return on invested capital is one of the best ways to calculate whether or not a company has a moat. Finding a company with a moat that gets a great return on its invested capital makes investing easy, not that this is an easy thing to find. The reason this makes it easy is the company can grow its value over the years and you can compound along with it; helping grow your wealth as it continues to add assets and grow its business.
The trick to finding a company that is a great allocator of capital is finding a company that has had success in the past getting a great return on invested capital. The higher the percentage, the better allocators they are.
Today, we are going to look further into return on invested capital. We will take a look at what it means and how to calculate it, along with examples for you to follow along.
Let's dive in.
Definition of Return on Invested Capital
What is a return on invested capital?
"Return on invested capital (ROIC) is a profitability ratio. It measures the return that an investment generates for those who have provided capital, i.e. bondholders and stockholders. ROIC tells us how good a company is at turning capital into profits." - Investinganswers.com
"We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year." - Charlie Munger, 2008 Berkshire Hathaway Annual Meeting
Another great thought from Charlie. I love this explanation and this is a great idea to strive for, finding a business that is conservatively financed that can write us a check every year. Better yet would be a company that in addition to giving us a dividend would be fantastic compounders.
What are compounders?
They are great quality businesses that can grow their intrinsic value at very high rates of return over long periods of time.
A business that can grow its intrinsic value at 12% to 15% over an extended period of time will create tremendous wealth for its shareholders over time. Regardless of what the economy does, or what the stock market does, or what the earnings reports say, etc.
We really like companies that can produce a really high rate of return on invested capital, but we also want companies that can reinvest large portions of those earnings at similar high returns within the business itself.
Warren Buffett's thoughts on Return on Invested Capital
We are going to turn again to his 2007 shareholder letter for some reference on his points regarding return on invested capital. I picked out some passages I thought were relevant to our post today. Buffett groups businesses into three groups according to his views on ROIC.
Businesses - The Great, the Good and the Gruesome
Category #1: The Great
"Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There's no rule that you have to invest money where you've earned it. Indeed, it's often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can't for any extended period reinvest a large portion of their earnings internally at high rates of return.
Let's look at the prototype of a dream business, our own See's Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn't grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See's, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry's earnings.
At See's, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See's sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See's family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.
We bought See's for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.
Last year See's sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth - and somewhat immodest financial growth - of the business. In the meantime, pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See's has given birth to multiple new streams of cash for us. (The biblical command to "be fruitful and multiply" is one we take seriously at Berkshire.)"
Category #2: The Good
"There aren't many See's in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That's because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.
A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See's situation. It's far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.
One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.
Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See's-like, return on our incremental investment of $509 million.
Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it."
Category #3: The gruesome
"Now let's move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
The airline industry's demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice."
Finally, he sums it all up with this savings account analogy.
"To sum up, think of three types of "savings accounts." The great one pays an extraordinarily high interest rate that will rise as the year's pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns."
The master at work, he makes it all sound so easy, doesn't he? As an aside, his thoughts on airlines have changed a lot recently with his purchases of Southwest (NYSE:LUV), Delta (NYSE:DAL), and American (NASDAQ:AAL). It is interesting how our thoughts about investments can change over time.
How to Calculate Return on Invested Capital
So, how do we calculate return on invested capital or ROIC? Thought you would never ask. The setup of the formulas is as follows. I am taking the lead from the great Aswath Damodaran here.
ROIC = Operating Income (1 - Tax Rate)/Invested Capital
Where:
After-tax Operating Income = Net Income + Interest Expenses (1 - Tax Rate) - Non-operating Income (1 - Tax Rate) Invested Capital (IC) = Short-term Debt + Long-term Debt + Shareholder Equity - Cash/equivalents - Goodwill
So, let's try this out on a couple of companies and see how this all fits together. I will use examples from the actual 10-K filings, so we can follow along. Any additional formulas needed I will add, so you know where the numbers actually come from.
Let's take a look at the 10-K for Apple (NASDAQ:AAPL). All numbers will be stated as millions unless otherwise noted.
Solving for the numerator: Step One
After-tax Operating Income = Net Income + Interest Expenses (1 - Tax Rate) - Non-operating Income (1 - Tax Rate)
Net Income can be found on Consolidated Statements of Operations
Net income = $45,687 million
Interest Expense
Interest Expense = -$1,456
The tax rate is calculated by dividing provision for income taxes by income before provision for income taxes. You can find both line items here on the income statement.
Income Taxes = $15,685
Income Before Taxes = $61,372
Tax Rate = $15,685/$61,372
Tax Rate = 25.56%
The last number we need is the non-operating income, which is a catch-all for dividend income, interest income or expense, or other expenses. This can all be found in the Notes to Consolidated Financial Statements, which is where you will be able to find explanations and breakdowns of different numbers in the financial statements. For Apple, it is found in Note 3 of this section and is broken down as this:
Non-operating Income = $1,348
So now, we can solve for the operating income portion of the formula.
Net Income = $44,687 Interest Expense = $Tax Rate = 25.56% Non-operating Income = $1,348
Now plug in the numbers into the formula and we get:
$44,687 + -$1,456 (1 - .2556) - $1,348 (1 - .2556) = $42,515.59
Solving for denominator: Step 2
Invested Capital (IC) = Short-term Debt + Long-term Debt + Shareholder Equity - Cash/equivalents - Goodwill
We will find all of these numbers on the balance sheet and I will provide screen shots to help you find them. Once we have them we will plug them into our formula.
First will be short-term debt.
Short-term Debt = $3,500
Next up will be long-term debt. Again, this will be found on the balance sheet under the liabilities and shareholders' equity section.
Long-term debt = $75,427
Now, we will locate the shareholders' equity, which will be found on the balance sheet under the same section.
Shareholders' Equity = $128,249
The last two numbers we can pull from the Assets section of the balance sheet. Cash and cash equivalents, plus goodwill will be subtracted out from the formula as they are not monies that are used to bring value to the company. Goodwill being a dumping spot for accountants and cash is typically kept in an account for a rainy day, if you will.
Cash/Cash equivalents = $20,484
Goodwill = $5,414
So, we have all of our numbers. Now, we can calculate our invested capital portion of the formula.
Short-term Debt = $3,500 Long-term Debt = $75,427 Shareholders' Equity = $128,249 Cash/Cash equivalents = $20,484 Goodwill = $5,414
Plugging these numbers into our formula gives us:
Invested Capital = $3,500 + $75,427 + $128,249 - $20,484 - $5,414
Invested Capital = $181,278
Now to calculate the return on invested capital for Apple, we will insert all the numbers into our formula and calculate everything out.
ROIC = Operating Income (1 - Tax Rate)/Invested Capital
Operating Income = $42,515.59 Tax Rate = 25.56% Invested Capital = $181,278
$42,515.59 (1 - .2556 )/$181,278
ROIC = 17.45%
ROIC of Apple is 17.4%. This is an awesome number. Ideally, you would like to see anything above 15%. So obviously, Apple is doing something right.
Let's do that for a company that maybe would be struggling to define a moat.
Let's try General Motors (NYSE:GM)
We are going to look at its 2016 10-K for our purposes today. You can follow along with the numbers that I will pull from its financials. It is on page 45 and will be under the income statement and the balance sheet.
10-K Item | Numbers | ||
Net Income | 9,268 | ||
Interest Expense | 572 | ||
Tax Rate | 20.68% | ||
Non-operating Income | 159 | ||
Short-term Debt | 29,028 | ||
Long-term Debt | 84,628 | ||
Shareholder's Equity | 43,836 | ||
Cash/equivalents | 12,960 | ||
Goodwill | 6,259 | ||
Now that we have the numbers, let's plug them into our formulas and see what we get.
ROIC = Operating Income (1 - Tax Rate)/Invested Capital
After-tax Operating Income = Net Income + Interest Expense (1 - Tax Rate) - Non-operating Income (1 - Tax Rate) Invested Capital (IC) = Short-term Debt + Long-term Debt + Shareholder Equity - Cash/equivalents - Goodwill
First, we will do operating income.
$9,268 + $572 (1 - .2086) - $159 (1- .2086) = $9,594.85
Next up will be invested capital.
$29,028 + $84,628 + $43,836 - $12,960 - $6,259 = $138,273
So, now we will calculate our formula for return on invested capital for GM.
ROIC = $9,594.85 (1 - .2086 )/$138,273
ROIC = 5.49%
As we can see by doing these simple calculations, it appears that GM does not possess a moat. As you start to dig into the numbers, you will see even before you calculate the formula whether or not the company will have a good return on invested capital.
Final Thoughts
The evaluation of companies is a many-layered process. You can use formulas like the one that we discussed today to start you on a path to discovering great investment opportunities.
We talked about the definition of return on invested capital and took some great looks into what some of the investing greats thought of this metric and their views on its use. Warren Buffett and Joel Greenblatt are two that come to mind.
As an aside, the shareholder letters of Warren Buffett are a treasure-trove of information, and if you are wanting to dive into his style and thoughts, they are a must read. Plus, his writing is easy to follow and very enjoyable. He uses wit and charm to help make his points, all without sounding preachy or boring.
I must mention one thing as we continue our process to discover great companies to invest in. You must not rely on one single formula to make your determination of whether or not you are going to invest your hard earned money into this business or not. Instead, these are tools we can use to help us find great opportunities to make better decisions.
Our goal always is to find great opportunities with a discount to their intrinsic value so we can buy with confidence.
As we have seen through our evaluations of these different companies, there appears to be a relationship between our calculations and the appearance of a moat. This requires further research into whether or not the numbers tell the whole story.
Sometimes, unfortunately, they do not, but they can be a great guiding force to uncovering the truth. As I mentioned in an earlier post, if it smells like a moat, it probably is a moat. But these calculations of return on invested capital can help you determine that fact a little easier.
There are tons of great resources out there if you are wanting to dive further into this topic.
Finally, I want to mention that you can absolutely do this. As you have seen in the last few posts, these calculations are not hard math. The most difficult part is finding the information to plug into the formulas, and once you have that, it is fairly easy to calculate.
That will do it for this week. As always, thank you for taking the time to read this post. I hope that you have found something of value to you.
Please share your thoughts with me as I would love to know how these formulas have helped you.
Take care,
Dave.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.