“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 their value over the years and you can compound along with it. Helping grow your wealth as they continue to add assets and grow their 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.