Warren Buffett's Favorite Investment Metric

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Welcome to Wealth Wednesday. We are going to talk about one of our favorite metrics to use when looking at stocks. In fact, it is a favorite of Warren Buffett as well.

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When you’re looking to invest in a company, you must consider countless numbers, ratios, and metrics.

But one that stands out among the rest, and is a favorite of legendary investor Warren Buffett, is ROIC — Return on Invested Capital.

Buffett loves this metric because it tells you something incredibly important: how effectively a company is using the money it has (its capital) to generate profits.

And while many investors chase high-growth stocks, Buffett has always leaned toward businesses with high ROIC because, over time, they tend to be the most sustainable and profitable.

In this post, we’ll break down what ROIC is, why it’s so powerful, and how Warren Buffett uses it to guide his investment decisions.

What is ROIC?

Let’s start simple. Return on Invested Capital (ROIC) is a financial metric that shows you how much profit a company is making from the money that’s been invested in it. This includes money from both shareholders (equity) and creditors (debt). It’s a way of seeing how efficiently a company turns its capital into profits.

Here’s a basic formula for ROIC:

That formula may look complicated, but don’t worry — here’s a real-world breakdown.

Think of it this way: if you were to start a lemonade stand and invested $100 into lemons, sugar, cups, and a table, and then, at the end of the summer, you made $20 in profit, your ROIC would be 20%.

In other words, you turned $100 of investment into $20 of profit. The higher your ROIC, the better you're using your capital.

Why does this matter for investors?

Well, if a company consistently produces high ROIC, it means it's very good at turning its money into more money.

That’s exactly the kind of business you’d want to own a piece of, right?

Real-World Examples of ROIC

To better understand ROIC, let’s take a look at two of the biggest players in the financial world: Mastercard and Visa.

Both are giants in the payment processing industry, but they’ve seen very different levels of success based on their ability to generate returns on their capital.

Mastercard:

Over the past five years, Mastercard has been consistently improving its ROIC, which shows that it’s using its capital more efficiently every year. And the result? Its stock has gone up 81.38% in the last 5 years.

That’s an incredible return, and a big part of why Mastercard is such a strong performer is because of its ability to generate high ROIC.

Visa:

Visa’s ROIC has also improved, but not at the same pace as Mastercard.

Over the last five years, Visa’s stock has increased by 54.95%.

Still a great return, but you can see how Mastercard’s ability to generate a higher ROIC has led to stronger stock performance over time.

These numbers highlight the power of ROIC. A company that can consistently grow its ROIC over time will often outperform those that don’t.

Mastercard and Visa are both fantastic companies, but Mastercard’s ability to generate higher returns on its invested capital has given it the edge in terms of stock growth.

Warren Buffett and ROIC

Let’s now turn to Warren Buffett, who’s a huge fan of ROIC. During Berkshire Hathaway’s 2021 annual shareholder meeting, Buffett was asked a question that gets right to the heart of why ROIC matters:

Buffett’s response was classic:

What Buffett is getting at here is that the best businesses are the ones that don’t need a lot of money to make a lot of money.

Take Apple, for example. Buffett pointed out that Apple only has about $37 billion in property, plant, and equipment, while Berkshire has over $170 billion. Yet, Apple is making far more money than Berkshire’s businesses.

Why? Because Apple’s business model is built around software, services, and digital products. Did you know that Apple gets 30% of every in-app purchase? For example, if you spend $10 on a monthly app subscription then Apple makes $3 from that.

In terms of their hardware, they are able to produce these products at a low price which allows them to have super-high margins.

Let’s compare that to a business like homebuilding.

If you run a construction company, you need a lot of money upfront to buy materials, hire workers, and build homes.

You also need land, equipment, and other expensive resources to grow your business. In contrast, a company like Apple can scale much faster with far less capital investment.

That’s what makes high-ROIC businesses so powerful.

Buffett also mentioned See’s Candy, which Berkshire acquired in 1972. He explained:

See’s Candy was one of Buffett’s best early investments because it didn’t require much capital to keep growing. The company generated a lot of cash, which Buffett used to invest in other businesses.

This is what high-ROIC businesses do — they create a snowball effect where profits keep rolling in, allowing for further investments and growth.

But as Buffett said:

So you might be wondering? Why don’t I just invest in every business with a high ROIC?

Here’s where things get tricky.

High-ROIC businesses are rare, and they don’t always stay that way. This is a key point.

Just because a company has a high ROIC today doesn’t mean it will maintain it forever.

For example, Yahoo was once one of the best companies in the world with a high ROIC.

But over time, it lost its competitive edge, and its ROIC dropped off.

It’s a reminder that your job as an investor is to assess how long a company can sustain its ROIC. You need to deeply understand the business and its competitive environment.

Buffett wrapped up the conversation by talking about utility businesses:

Buffett is saying that while utility companies don’t offer the dazzling ROIC you might see from tech companies, they offer predictability.

With a utility company, you know where it’s going to be in 10 years. People will still need electricity, water, and other essential services, and there are fewer competitors in this space.

The returns may not be flashy, but they are steady and reliable.

Contrast that with tech companies like Apple or Google. While they may deliver massive ROIC today, you never know who will emerge with the next big innovation that could change the game.

Someone could come out of nowhere with the next breakthrough smartphone, platform, or app that steals the spotlight.

For Buffett, the risk with high-ROIC businesses is that their dominance isn’t guaranteed to last.

And yet, despite this caution, Buffett’s largest position is Apple, which shows that he recognizes the value in balancing predictable, lower-return investments with high-ROIC businesses that have the potential for massive upside.

It’s a balancing act.

ROIC is one of the most critical metrics for understanding a company’s ability to generate profit from its capital.

Warren Buffett’s insights show us that while high-ROIC businesses like Apple and Google are incredibly powerful, there’s always a balance to strike between growth and predictability.

Talk to you on Sunday!

Cheers,

The Bean Team

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