Return on invested capital is often an under-utilized metric when searching for high quality stocks.
Investors who ignore return on invested capital as a means of evaluating stocks can miss out on companies that are making good use of invested capital. Warren Buffett, perhaps the most successful investor of all time, often stresses the importance of looking at return on invested capital when making an investment decision.
If the Oracle of Omaha finds it a worthwhile metric to consider, then we feel that the average investor should as well.
This article will examine what the metric is, why it is important, and provide a few examples of companies with excellent returns on their invested capital. The stocks are:
What is Return on Invested Capital?
Companies typically have to borrow capital to grow the business. The old adage “it takes money to make money” is often very true in business. In order to grow earnings, companies usually have to invest to increase its ability to produce more goods and services.
Each investment of capital should be expected to grow future earnings. Those companies that don’t successfully reinvest in the business are at risk at seeing results plateau or, worse, decline.
Return on invested capital is calculated by dividing the company’s net operating profit after taxes by the combination of debt and equity. This quick ratio can tell investors how successful the company has proven itself at properly allocating capital within its business. A healthy return on invested capital varies across industries, but a figure above 10% is usually what passes as a solid rate.
Buffett often stresses the importance of this return as a means of detecting strong businesses to own.
In his 1992 Berkshire Hathaway Shareholder letter, Buffett wrote:
“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.”
Buffett is clearly looking to identify the companies that are best at extracting value out of invested capital.
The reason is that companies that can achieve a higher rate of return on capital are often those that can outpace the competition. The ability to do so can lead to better business results. Companies outperforming their peer groups often have stocks that enjoy a valuation superior to that of its competition.
On the other hand, companies that make poor investment decisions are essentially destroying shareholder value. For this reason, we feel that investors should consider owning companies that have high a return on invested capital ratio.
Why is Return on Invested Capital Important?
Measuring this return provides investors with a way to evaluate management’s effectiveness.
Regardless of size, good management teams are needed for businesses to succeed. There are multiple examples throughout history of large, iconic companies who lost their way because of poor managerial decisions. If a company’s leadership is showing weak or declining return on invested capital it will show up fairly quickly using this metric.
Good management teams can also use return on invested capital to measure what return their reinvested dollars are producing. This figure can help assist with planning, budgeting and evaluating where reinvested dollars should go. That way, management teams can pivot their strategy if they determine that capital isn’t being used wisely in one area of the business.
Finally, this statistic is a tool that investors can use to compare between two companies in the same sector. For example, if company ABC is earning a 15% return on invested capital while company DEF is earning just 5%, investors can see that the former is considerably better at turning invested capital into profits.
Examples to Consider
One of the best examples of a company that has seen high rates of return on invested capital is Apple.
The then-focused computer company was on the verge of bankruptcy in the mid-1990s. A lack of innovation had almost doomed the company, but Apple invested immense amounts of capital into its business to create products that consumers would purchase.
As a result, Apple has created an entire ecosystem as consumers now buy millions of units per year of the company products, which include iPhones, Macs, iPads, the Apple Watch and Apple TVs. Apple has a return on invested capital of 54%, meaning that the company is generating $1.54 of earnings for every dollar that it has invested. This is a primary reason that Apple is now one of the largest companies in the world.
Companies with strong return on invested capital ratios are found in a wide variety of industries. Take Domino’s Pizza, for example.
For many years, Domino’s was just like every other pizza chain, but the company began to invest heavily in technology. The ease of use has attracted customers at considerably higher rates than its competitors.
Today, Domino’s has more than 18,000 stores worldwide, making it the largest pizza chain in the world. Domino’s has so successfully reinvested in its business to grow earnings that its return on invested capital is 59%.
One final example of a company posting incredibly high rates of return on invested capital is AutoZone. The company, which is a leading retailer and distributor of automotive replacement parts, has a return on invested capital of 110%.
The company was able to achieve this level of return because it moved to aggressively expand its store count to more 6,000 across the U.S., Puerto Rico, Mexico and Brazil.
The automotive replacement part business is highly fragmented with many smaller and independent operators. This store expansion allowed AutoZone to increase its market share at the expense of the smaller players in its industry.
With so many ways for investors to value stocks, investors might not realize that return on invested capital is an excellent way to see how efficiently companies are generating earnings from investments in the business.
This can help separate the great companies from the mediocre, which can lead to outsized returns for a portfolio. Investors wishing to understand how Buffett became the investor that he is would do well to add this figure to their investment tool kit.
On the date of publication, Bob Ciura did not have (either directly or indirectly) positions in any of the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.