Do These Video Game Makers Pass Buffett's Test?

We'd all like to invest as successfully as the legendary Warren Buffett. He calculates return on invested capital to help determine whether a company has an economic moat -- the ability to earn returns on its money beyond that money's cost.

ROIC is perhaps the most important metric in value investing. By determining a company's ROIC, you can see how well it's using the cash you entrust to it, and whether it's actually creating value for you. Simply put, ROIC divides a company's operating profit by the amount of investment it took to get that profit:

ROIC = Net operating profit after taxes / Invested capital

This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.

Ultimately, we're looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses lands between 8% and 12%. Ideally, we want to see ROIC greater than 12%, at minimum. We're also seeking a history of increasing returns, or at least steady returns, which indicate that the company's moat can withstand competitors' assaults.

Let's look at Activision Blizzard (Nasdaq: ATVI) and two of its industry peers to see how efficiently they use capital. Here are the ROIC figures for each company over several time periods:

Source: Capital IQ, a division of Standard & Poor's. * Assumes TTM tax rate of 17.1%. ** Assumes 2006's effective tax rate of 37.8%. *** Assumes effective tax rate of 27.7% for consistency with earliest period five years ago.

At first blush, there seems to be little to like here. Among typically lucrative software makers, these video game makers stand out like a sore Nintendo thumb. Activision Blizzard's ROIC is the best of the lot in the last four quarters, but the company recently took part in a consolidation, which makes earlier figures not very comparable. Electronic Arts has shown a dim performance recently, while Take-Two seems to be pulling out of a dive in its ROIC, but can it continue the trend? What's going to make these returns more attractive?

Businesses with consistently high ROIC are efficiently using capital. They can use their extra returns to buy back shares, further invest in their future success, or pay dividends to shareholders. (Warren Buffett especially likes that last part.)

To unearth more successful investments, dig a little deeper than the earnings headlines, and check up on your companies' ROIC.

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