Does Tesoro 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 Tesoro (NYSE: TSO) 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

(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 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.

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because TSO did not report an effective tax rate, we used its 36% rate from three years ago.
**Because WNR did not report an effective tax rate, we used its 34.5% rate from TTM.
***Because CPNO did not report an effective tax rate, we used its 27.3% rate from five years ago.

Tesoro, like the other companies, has seen some heavy declines in its returns on invested capital from five years ago, but it has improved those returns since then. Western Refining has seen even worse declines, but it still has the highest ROIC of the companies and has also improved its returns dramatically from last year. Copano's and Valero's ROIC have declined by more than half from five years ago, but Valero has shown significant increases from last year, and neither sits at particularly attractive levels.

With better ROIC, both Tesoro and Western Refining performed well over the last year, rising 18% and 40% against a 15% loss for Valero. Hefty dividend payer Copano saw a 12% increase in share price.

Things are also looking up for the company in that heavier oil remains cheaper than light sweet crude, which means more business for refineries like Tesoro and Western Refining. That price disparity has also allowed the companies to increase the spread between the price they pay for crude oil and the price they charge for gasoline and heating oil. That has allowed profits to grow very quickly over the past year or so.

Valero offers a 2.9% dividend and Copano Energy a 6.7% yield, while Tesoro and Western Refining fail to offer any dividend at all.

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. Add these companies to your Watchlist:

• Add Western Refining to My Watchlist.
• Add Valero Energy to My Watchlist.
• Add Tesoro to My Watchlist.
• Add Copano Energy to My Watchlist.