Does Flowserve 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 Flowserve (NYSE: FLS  ) 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

Flowserve 14.6% 16.4% 20.4% 6.6%
Graco (NYSE: GGG  ) 33.3% 23.7% 30.4% 32.8%
Gorman-Rupp (Nasdaq: GRC  ) 14.5% 11.7% 17.0% 13.5%
IDEX (NYSE: IEX  ) 9.4% 8.7% 10.4% 11.6%

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

Flowserve's current returns on invested capital fall in the middle of the pack, and while they are up from five years ago, they have declined steadily over the past three years. Gorman-Rupp has comparable current returns, which are up slightly from five years ago, but down several percentage points from three years ago. Graco's current returns are more than twice those offered by its industry peers, and the figures have held steady over the last half-decade, a very good sign. IDEX is the lowest performer, with current ROIC more than 2 percentage points lower than they were five years ago.

While Flowserve's ROIC does not stand out among industry peers, its dividend had a 20.9% growth rate over the past five years, against Graco's 7.3% and IDEX's 9.6%. While we like to see dividend growth, investors would do well to investigate whether their investments can maintain those growth rates (or even sustain the dividend) in the future. In that regard, Flowserve's 22.5% average ROE over the past three years is promising. However, Flowserve ties with Gorman-Rupp for offering the lowest dividend yield with 1.3%. IDEX, on the other hand, offers a 1.9% dividend yield and Graco offers a 2.3% yield.

Even more encouraging for Flowserve is that its operating and net margins are both significantly above their five-year averages, meaning that the company's performance is trending up even in a difficult environment. That should bode well for the dividend and Flowserve investors.

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. 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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