The Best Businesses To Own

In his Annual Letter to Shareholders in 1992, legendary investor Warren Buffett stated the following:

"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. The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return."

So how do you know how well a company is employing its capital? Look at its Return on Invested Capital.

ROIC Defined

Return on Invested Capital (ROIC) is calculated as:

Net Operating Profit After Taxes / Invested Capital

Invested capital is broken down further as Total Assets - Excess Cash - Non-Interest-Bearing Current Liabilities.

An ROIC of 15% means that for every $1 of capital invested in a business, 15 cents of after-tax income was created during that period. The best companies generate returns above their weighted average cost of capital (WACC).

The weighted average cost of capital is the minimum return required to satisfy all investors, including creditors and shareholders.

Companies with ROIC greater than their WACC are creating value for their owners. They are earning superior risk-adjusted returns for investors and generating positive economic profits.

On the other hand, companies with ROIC below their cost of capital are destroying value for shareholders. They are earning returns below what the market requires for assuming the risk of investing in the company.

EPS Growth Does Not Equal Value Creation

It is important to note that just because a company is growing its earnings per share doesn't mean that the growth is profitable.

Assume a company dumps $1 billion of capital into a project that generates $50 million of earnings next year. Sure earnings grew, but it produced a return of just 5%. That $1 billion in capital would have been better used elsewhere.

Conversely, if the company can generate $50 million in earnings from an investment of, say, $250 million, that's a much better 20% return.

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