We’d all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, to help determine whether a company has an economic moat — the ability to earn returns on its money above that money’s cost.
In this series, we examine several companies in a single industry to determine their ROIC. Let’s take a look at Exelon Corporation (NYSE:EXC) and three of its industry peers to see how efficiently they use cash.
Of course, it’s not the only metric in value investing, but ROIC may be the most important one. By determining a company’s ROIC, you can see how well it’s using the cash you entrust to it and whether it’s actually creating value for you. Simply put, it divides a company’s operating profit by how much investment it took to get that profit. The formula is:
ROIC = net operating profit after taxes / Invested capital
(Get further detail on the nuances of the formula.)
This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and it provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.
Ultimately, we’re looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company’s economic moat.
Here are the ROIC figures for Exelon Corporation (NYSE:EXC) and three industry peers over a few periods.
| Company | TTM | 1 Year Ago | 3 Years Ago | 5 Years Ago |
|---|---|---|---|---|
| Exelon | 2.8% | 3.7% | 6.5% | 7.2% |
| The Southern Company (NYSE:SO) | 4.3% | 4.8% | 5.1% | 5.2% |
| Duke Energy Corp (NYSE:DUK) | 3.1% | 3.9% | 3.1% | 3.9% |
| Dominion Resources, Inc. (NYSE:D) | 5% | 5.1% | 5.2% | 4.5% |
Source: S&P Capital IQ. TTM=trailing 12 months.
Dominion Resources has the highest returns on invested capital at 5%, and it has maintained returns close to those rates over the past five years.
Exelon Corporation (NYSE:EXC) has exposure to a wide range of energy sources, including nuclear, renewable, and fossil-fuel energy. This helps shelter the company from declines in demand for a particular energy source. For example, new regulations requiring coal-fired plants to convert to gas-fired plants initially looked like they would deal a much larger blow to companies like Southern and Duke, which relied heavily on fossil fuels, than it did to the more diversified Exelon Corporation (NYSE:EXC).
