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Four Cheap Companies that Create Value

Harness the power of high returns on invested capital.

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My favorite financial ratio is--hands down--return on invested capital, or ROIC. I think it's 10 times better than return on assets (ROA) or return on equity (ROE), and net profit margin doesn't even come close. That's because it single-handedly provides a quantitative answer to the question, "Does this company have an economic moat?" (The idea of an economic moat refers to how likely companies are to keep competitors at bay for an extended period.) Given how great the ROIC metric is, I wish there was a stock screener that would help me find companies with high ROICs, but unfortunately one doesn't exist. So let me show you how to calculate ROICs, and then you'll be able to conduct a sniff-test of a company's economic moat by yourself. I'll also discuss some companies that are high-ROIC machines and happen to be selling at 5-star prices. But first let's talk about what exactly ROIC measures, and why it's superior to all other financial ratios.

ROIC is a measure of how much cash a company gets back for each dollar it invests in its business. You're probably saying, "That sounds so similar to ROA and ROE, why not just use those, since they're posted on just about every financial Web site?" I agree that using ROA or ROE would be easier, but in my book they just don't cut it. First of all, the numerator in both of these ratios is net income. In many cases a company's net income has nothing to do with how profitable its operations are. There can be so many things going on "below the line"--interest income, discontinued operations, minority interest, and so on--that net income can make companies with unprofitable operations look profitable, and vice versa.

Further, ROA measures how much net income a company generates for each dollar of assets on its balance sheet. The problem with using this metric is that companies can carry a lot of assets that have nothing to do with their operations, so ROA isn't always an accurate measure of profitability.

ROE looks at how much profit a company makes per dollar of shareholders' equity. Theoretically ROE is a great metric because it measures how efficiently a company is using shareholders' money to generate profits--and as investors, that's something we should care about. But ROE has its limitations, too. By carrying high debt levels and repurchasing shares, management can increase a company's financial leverage, and thus its ROE, but too much of either can produce an unreasonably high ROE that doesn't accurately represent the company's profitability.

As far as net profit margin goes--which is net income divided by sales--frankly, I could care less. Sure it measures how efficient a company is with each dollar of revenues, but that's the money its customers give it. As an investor, I care about what the company does with investors' money. And since net profit margin doesn't tell us anything about the balance sheet, you would never know if a company is posting great margins simply because it's interminably shoveling cash into its business. That can't go on forever.

So how do we calculate ROIC? For the "return" part of ROIC, we don't use net income, but rather earnings after taxes but before interest payments. We do this so that companies won't be penalized for having a lot of debt (and thus high interest payments). For the "invested capital" part, we take all of the company's assets, then subtract all current liabilities (those due within a year) except for short-term debt. Dividing aftertax income by invested capital gives us ROIC. Here's what it looks like:

1. Aftertax income = (operating income) * (1 - tax rate)
2. Invested capital = total assets - (current liabilities - short-term debt)
3. ROIC = aftertax income / invested capital

The beauty of ROIC is that you can make any adjustments that you think are necessary. For example, if I think that a company has a lot of cash on its books that isn't being used for operating purposes; I'll subtract this "nonoperating cash" from total assets. Or if the company is actually paying a lot less in cash taxes than what's showing up on the income statement, I'll add the difference back to the "aftertax income" figure. On the flipside, the fact that an investor needs to make some judgment calls in calculating ROIC is probably what's keeping the metric out of stock screeners.

ROIC by itself doesn't tell us much about a company's economic moat. A company creates value only if its ROIC is higher than its weighted average cost of capital, or WACC. The WACC measures the required return on the company's debt and equity, and takes into account the risk of the company's operations and its use of debt. WACCs typically range between 9% and 12% for large-cap companies, although there are many exceptions. Companies that have generated ROICs higher than their WACC for many years running usually have a moat. But a positive spread between ROIC and WACC alone doesn't justify an economic moat. Investors also have to think about the qualitative attributes--huge market share, low-cost production, corporate culture, or high customer switching costs--that create an economic moat around a company's profits. Here's how you can use ROIC: If you think a company has a great business model that enjoys an economic moat, check to see if its historical ROICs are greater than its WACC. If they are, chances are you've found a company that will continue to generate value for its shareholders.

Now let's look into four companies that are ROIC winners. These companies also happen to be trading at prices well below our analysts' fair value estimates here at Morningstar, so we would consider buying these stocks. The stocks mentioned here had 5-star ratings--or "consider buy" prices--as of Oct. 25, 2005. The star ratings may change daily due to price fluctuations or other factors. (Special note: During Morningstar.com's Premium Stock Research Week--until Oct. 30--you are invited to view all of Morningstar.com's Stock Analyst Reports free of charge. Click here for more information.)

Boston Scientific (BSX)
Business Risk: Average
Economic Moat: Wide
Medical device producer Boston Scientific generated a 25% ROIC last year, and Morningstar health-care analyst Debbie Wang thinks that ROICs will top 35% over the next five years, thanks to its focus on high-margin, value-added devices. From the  Analyst Report: "We particularly like how the firm has turned its attention toward developing more complex, highly engineered devices that can command higher margins and are less vulnerable to commodification." That certainly sounds like a wide economic moat to me! Boston Scientific's impressive ROICs should be intact for years to come.

Yankee Candle Company (YCC)
Business Risk: Average
Economic Moat: Narrow
This premium scented candle company has generated ROICs of over 20% on average during the last five years, and consumer goods analyst Kimberly Picciola predicts that ROICs will best 30% over the next five. From the  Analyst Report: "Yankee Candle has garnered a 40% share of the premium scented candle market and has developed a vertically integrated manufacturing process, enabling it to control the quality and production costs of around 74% of its products. Yankee Candle's move to position itself as an 'affordable luxury' brand has paid off and consumers are willing to pay a premium for its products. Also, Yankee Candle does not engage in competitive discount pricing, which has enabled it to achieve solid margins on a consistent basis." Notice that Yankee Candle has two key attributes of a company with an economic moat: huge market share and low-cost productions. This should provide some protection against competitors chipping away at its impressive returns.

Washington Post Company (WPO)
Business Risk: Below Average
Economic Moat: Wide
Media analyst James Walden thinks Washington Post's ROICs should be greater than 25% (excluding goodwill) for the next few years, thanks to its recent investments in cable and education businesses. Washington Post also has a unique corporate culture that stresses long-term results, an important sign of an economic moat. From the  Analyst Report: "Washington Post is best known for its flagship newspaper and Newsweek magazine. Perhaps less well-known is that the company also owns and operates several TV stations, which normally throw off loads of cash thanks to operating margins that approach 50% during election years. Beyond its solid line of businesses, one of Washington Post's greatest assets is its management. The executive team continually emphasizes long-term improvement over quarterly forecasts."

Oracle (ORCL)
Business Risk: Average
Economic Moat: Wide
Software giant Oracle has generated average ROICs that were well above 25% over the last five years. Mike Trigg, technology analyst and editor of Morningstar GrowthInvestor, predicts that ROICs will remain just as high over the next five. Oracle's business model illustrates that there's two important components of generating noteworthy ROICs: producing high after-tax income and having low invested capital needs. Software companies have lower capital requirements--in other words, they're able to do more with less. From the  Analyst Report: "The high switching costs associated with database software provide Oracle with a wide economic moat. Switching database vendors can present a variety of problems, including having to rewrite code, hire and train new people, and alter the data. Switching costs provide Oracle with a lock on its 200,000-plus database customers and make its excess returns sustainable for some time. The strength of maintenance revenue highlights the importance of Oracle's installed base. Nearly all of its customers pay an annual fee for upgrades and support. Not only is maintenance recurring and highly profitable because expenses can be spread across a giant base, but it should also continue to grow as Oracle's number of customers increases. Finally, Oracle is relentless in cutting excess costs."

Elizabeth Collins does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.