Return on Invested Capital

The best way to determine whether or not a company has an economic moat is to measure its return on invested capital (ROIC). This is similar to ROA (return on assets) but is a bit more involved. The upshot is it gives the clearest picture of exactly how efficiently a company is using its capital, and whether or not its competitive positioning allows it to generate solid returns from that capital.

ROIC = Net Operating Profit after Taxes (NOPAT) / Invested Capital (IC)

Notice the numerator is a nonstandard measure, meaning you will not find it on any standard financial statement. We have to calculate it ourselves. The name "net operating profit, after taxes" is fairly descriptive, but you can also think about NOPAT as simply net income with interest expense (net of taxes) added back. We do this to figure out what the profit would be without taking a company's capital structure into consideration.

NOPAT = (Operating Profit) x (1 - Tax Rate)

For the denominator, invested capital is yet another nonstandard, calculated measure not found on any financial statement. Invested capital tries to measure exactly how much capital is required to operate a business. It can be defined as such:

IC = (Total Assets) - (Excess Cash) - (Non-Interest-Bearing Current Liabilities)

This equation introduces two new terms that need some explanation. Excess cash can be defined as the cash a company has that is not required to operate the business. For example, a huge company clearly does not need the full $35 billion in cash and investments it has in its war chest to keep the business running, and we can subtract a portion of that cash because that capital is not really invested in the business.

The most salient example of a non-interest-bearing current liability is accounts payable. The reason we subtract accounts payable from the invested capital base is because, if you think about it, accounts payable represent capital invested in the business by a company's suppliers, not the company itself. Other forms of liabilities that we should probably subtract out are deferred revenues and deferred taxes. (We say "probably" because, like excess cash, determining what liabilities do and do not represent invested capital requires a lot of judgment.)

Once you have gone through the exercise of calculating an ROIC for a company, how do you know if it has a wide moat? Typically, if a company has an ROIC in excess of 15% for a number of years, it most likely has a moat. That said, whether a company is creating value depends on whether its ROIC exceeds its cost of capital.