Does Capstone Turbine 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, in order 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 take a look at several companies in a single industry to determine their ROIC. Let's take a look at Capstone Turbine (Nasdaq: CPST  ) 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 actually 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

The nuances of the formula are explained in further detail here. 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 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 four industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Capstone Turbine (75.1%)* (68%)* (97.9%)* (185%)*
Cummins (NYSE: CMI  ) 23.6% 13.9% 14.9% 15.8%**
Briggs & Stratton (NYSE: BGG  ) 6.1% 5.8% 1.8% 6.1%
Navistar International (NYSE: NAV  ) 5.2%*** 8.5% 6.3% 6.9%

Source: S&P Capital IQ. TTM = trailing 12 months. *Because CPST did not report an effective tax rate, we used a 35% rate. **Because CMI did not report an effective tax rate, we used its 32.5% rate from three years ago. ***Because NAV did not report an effective tax rate, we used its 24% rate from five years ago.

Capstone Turbine is looking pretty rough, with returns on invested capital well into the negative numbers due to negative earnings before interest and taxes. However, it has shown some improvement from five years ago. All of the other listed companies have returns above 5%, with Cummins offering returns above 23%, suggesting that it has gained competitive position over the last few years.

Capstone brought in a lot of interest around 2005 when Jim Cramer recommended it as a play in alternative energy and because of a report that Wal-Mart would buy a large number of Capstone's turbines. At that time, the company also had a strong working relationship with United Technologies.

Despite this early promise, Capstone has consistently failed to turn a profit, and is burning through cash at high rates. Given this huge string of losses, it's almost amazing that investors continue to fund the company.

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. If you'd like to add these companies to your Watchlist, click below:

Jim Royal, Ph.D., does not own shares of any company mentioned here. The Motley Fool owns shares of Wal-Mart Stores. Motley Fool newsletter services have recommended buying shares of Wal-Mart Stores and Cummins, as well as creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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  • Report this Comment On December 11, 2011, at 5:17 PM, Indiscr33t wrote:

    <it's almost amazing that investors continue to fund the company.>

    Looks like the market makers are making the market and you're stuck here writing about it. Happy shorting, as clearly a company not yet profitable will of course not meet any of Buffett's various tests. DNN is another loser I rode from $1.19 to $3. Your article is the intellectual equivalent to examining if blue is a color. Money may be made anywhere from absolutely ANY macro or micro trend.

    "That the (failing system) continues is nothing short of amazing."

    and this is where u can be a little better informed than the herd

    failure takes a long time

    the herd is "amazed" by this

    don't be amazed, factor it in

    slowly executing failure exists all around us

    so first, there comes the writing on the wall

    then the long period where the survival instincts prevail, and somehow we miraculously keep bouncing back up off the floor

    the crowd thinks the writing on the wall was a misnomer

    but we realize, it just takes a lot longer than most expect to play out

    successful people understand this,

    and you clearly do not.

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