Five Cheap Companies that Create Value

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 couldn't 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) x (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--high barriers to entry, huge market share, low-cost production, corporate culture, patents, 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 five 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 Morningstar Ratings of 5 stars--or "consider buying" prices--as of midday on Feb. 7, 2006. The star ratings may change daily due to price fluctuations or other factors.

Strayer Education (STRA)
Business Risk: Average
Economic Moat: Wide
Strayer--a for-profit post-secondary education company--has generated ROICs that have averaged 95% since 2001, the year the current management team joined the company. Stock analyst Kristan Rowland predicts that ROICs will top 110% in the future. From the  Analyst Report: "For-profit education is very profitable, with wide-moat companies such as  Apollo Group   and Strayer generating returns on invested capital north of 90%. We think these outsized returns are sustainable because of the industry's high barriers to entry. Top-flight firms such as Strayer possess regional accreditation, which is difficult to obtain and contributes to their moats. Membership follows a period of candidacy lasting up to five years, and periodic reviews are required for continued accreditation. Regional accreditation also helps Strayer attract students because it is indicative of quality. Furthermore, it allows institutions to tap into federal student-aid programs, expanding the pool of students that they can attract."

Johnson & Johnson (JNJ)
Business Risk: Below Average
Economic Moat: Wide
Diversified health-care company Johnson & Johnson has posted ROICs of 25%, on average, during the last five years. Stock analyst Tom D'Amore expects ROICs to be greater than 30% over the next five years. From the  Analyst Report: "We think Johnson & Johnson is an exemplary wide-moat company--it boasts trusted brand-name products, world-class R&D and marketing capabilities, and global scale and reach. A key reason for J&J's success is its decentralized management structure--the company encourages entrepreneurship among local managers to stimulate creative new product development. Sales and marketing expertise and quality manufacturing skills are important distinguishing core competencies. In addition, the company keeps a careful watch on costs, which shows in the steady improvement in operating margins."

3M Company (MMM)
Business Risk: Below Average
Economic Moat: Wide
Manufacturing company 3M has generated 18% ROICs over the last five years, on average, and stock analyst Scott Burns is forecasting ROICs of over 24% over the next five years. From the  Analyst Report: "Innovation and strong manufacturing capabilities have long been the trademarks of this company. 3M is synonymous with research and development and a corporate culture that breeds innovation. Another of 3M's advantages is its ability to leverage technologies across different businesses and continuously find new uses for basic technologies. In addition, 3M fiercely protects its patents and uses its protected period to perfect its production processes. Combining this production expertise with the company's global manufacturing base makes it cost prohibitive for rivals to undercut its prices once items fall off patent."

Fastenal (FAST)
Business Risk: Below Average
Economic Moat: Narrow
Fastenal supplies customers, including manufacturers and commercial construction contractors, with 250,000 varieties of threaded fasteners and 265,000 general-purpose maintenance, repair, and operations products. ROICs have topped 19% on average over the last five years, and stock analyst Matthew Warren expects returns to exceed 24% over the next five years. From the  Analyst Report: "Fastenal has translated its unique competitive position into decades of profitable growth. This well-oiled machine continues to turn out new stores and take share in a highly fragmented market. By offering more than a quarter million types of fasteners (and a similar variety of maintenance, repair, and operations--or MRO--products) through its 1,700-plus stores, Fastenal provides enhanced selection and more convenience than broad-line distributors or hardware stores. Also, the company's 12 distribution centers and in-house truck fleet provide a highly efficient path to market, especially for heavy fasteners, which are expensive to ship via parcel carriers. Fastenal's unique offering is rewarded with pricing power--an important attribute, given recent steel price fluctuations."

Sysco (SYY)
Business Risk: Below Average
Economic Moat: Wide
Sysco--a provider of food-service products--has posted 19% ROICs over the past five years, and stock analyst Greggory Warren expects this strong performance to continue. From the  Analyst Report: "Sysco is the dominant food-service distributor in North America. The company generates impressive returns in what has traditionally been a low-margin business, using economies of scale, investments in technology, and a cadre of marketing associates armed with a portfolio of its own branded products to cement its position. Sysco exhibits the very traits we look for in a wide-moat company. Being the market leader in such a highly fragmented industry allows Sysco to grab share from weaker competitors and gives it prime access to customers and acquisitions. We believe part of Sysco's success stems from its unparalleled economies of scale. The food distribution business has high fixed costs, which means that only companies capable of spreading those costs over a larger base will generate above-average returns. Finally, Sysco's investments in technology and in its distribution network have allowed it to lower its procurement and delivery costs and cement its position as the low-cost provider in the industry."