photo © 2009 Amy Gizienski | more info(via: Wylio)
In the article about economic moat, we have discussed about its basic concepts and how it is useful for investors. You may be wondering if there are quantitative ways to know whether the company has an economic moat.
Well, there is. It’s called the Return on Invested Capital ratio. It measures how much the company is earning per dollar invested. For simplicity, let us assume that you started a lemonade stand. What do you need to start a lemonade stand?
Here’s the list:
- Cart with an umbrella on it.
- Inventories such as freshly squeezed lemonade, sugar and crushed ice
- Paper sign that says, “Fresh Lemonade Juice”
Assume further that you need $100 to buy those materials. That’s your invested capital. At the end of the year, you earned (sales deducted by expenses) $10 from your lemonade stand. This now your return. You now divide your return over your invested capital and you know have the ratio. In this case, you have a 10% return on invested capital.
I know what you’re thinking. This is too simplified. Let’s do things like an investment pro. Here are some steps:
- Look for the latest annual report or financial statements of the company you’re interested.
- Go to the income statement. Look for the line “operating profit or income.” If you can’t see that, it can be computed as Revenues minus Operating Expenses.
- After the operating profit, there’s a line that’s called, “taxes.” Deduct that amount from the operating income. Write down that amount. We will use that as our numerator.
- Next, let’s us go to the balance sheet. Please find the account that says, “Total Assets.”
- After getting total assets, deduct it with cash and non-interest bearing current liabilities. You know have your denominator.
- Note: For non-interest-bearing current liabilities, you eliminate the Short Term Borrowings like Bank Debt, Notes Payable, ALL Current Portion of long term debt. What you want is those trade payables, accruals, etc.
- Deduct the numerator by the denominator. Make it as percentage.
Here’s some real example. Let’s try computing the Return on Invested Capital of Coca-Cola. Please click on the latest 10-k or 2010 Annual Report here. Alternatively, you can also find it on its Investors Relation website.
Go to page 88 – the Income Statement under 2010 column. You can find that the operating income is $8.4 billion and taxes at $2.4 billion. Your numerator is $6 billion.
Now, please move to page 89 – Balance Sheet. Under the 2010 column, total assets is $72.9 billion. Deduct it with cash and cash equivalents of $11.2 billion and Non-Interest Bearing Current Liabilities of $11.6 billion (Just deduct Total Current Liabilities by Loans and Notes Payable and Current Maturities of Long Term Debt). Your denominator is now $50.10 billion
Divide the numerator by denominators? It’s 11.98%. That’s your Return on Invested Capital.
Another question you might ask is whether the 11.98% Ratio would mean that the company does have an economic moat. Well, it depends but it should be based on the following:
- If the return on invested capital is higher than the cost of its funds (Yes, that’s for another day’s topic).
- If the return on invested capital is higher than its competitors. Average Return on Invested Capital is 10%. Anything higher than that would indicate an “economic moat”
- If the return on invested capital is consistent or stable. Compare the ratio from the previous years (Ideally 5 year-period). A high one-year ratio would mean an “extraordinary” good year.
A word of caution, though. There are companies whose business model requires little or no capital. Think of distribution companies and franchise-based business model. In this case, invested capital is irrelevant. The best way is not to look at this ratio but use quantitative factors which will be discussed in another post.
There are other ratios that could also indicate the presence of economic moat like higher cash balances, higher margins, average price increases, etc. But this ratio is more than enough to tell you whether the company has competitive advantage or not.
The higher this ratio, the better. For me, anything above 15% will invite me to dig deeper.
How about you? What’s your economic moat indicator? Glad to hear your views and opinions.