Does McKesson Pass Buffett's Test?

We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.

In this series, we examine several companies in a single industry to determine their ROIC. Let's look at McKesson (NYSE: MCK  ) and three of its industry peers, to see how efficiently they use cash.

Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's creating value for you. Simply put, it divides a company's operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / Invested capital

(Read more about the nuances of the formula.)

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 it 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 is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Here are the ROIC figures for McKesson and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

McKesson 18.1% 18.3% 13.2% 15.6%
AmerisourceBergen (NYSE: ABC  ) 28.6% 23.5% 16.3% 11.8%
Cardinal Health (NYSE: CAH  ) 13.2% 15.3% 10.5% 13.4%
Owens & Minor (NYSE: OMI  ) 12.4% 13.4% 11.6% 8.1%

Source: S&P Capital IQ. TTM=trailing 12 months.

Mckesson's returns on invested capital are a few percentage points higher than they were five years ago. AmerisourceBergen and Owens& Minor have seen more growth in their ROIC over the same time period, while Cardinal Health has seen a small decline.

McKesson's competitive advantage largely lies in the fact that it, along with Cardinal Health and Amerisource Bergen, is part of a near-oligopoly of wholesale pharmaceutical distributors, making it difficult for new competitors to gain entrance.

And although recent health-care reform has brought uncertainty into the sector, McKesson may stand to gain from some of these changes. For example, as the number of newly insured patients rises, McKesson will have more potential customers for its generic drugs, which tend to produce higher profit margins than brand-name drugs do.

Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.

So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. Feel free to add these companies to your Watchlist:

Jim Royal, Ph.D., owns no shares of any company mentioned here. Motley Fool newsletter services have recommended buying shares of McKesson. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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