Five Cheap Companies that Create Value
Harness the power of high returns on invested capital.
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.
Elizabeth Collins does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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