Does Terra Nitrogen 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 Terra Nitrogen (NYSE: TNH  ) 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

(Get further detail on 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 four industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Terra Nitrogen 561.2% 235.9% 566.7% 54.1%
Mosaic   (NYSE: MOS  ) 21.9% 16.1% 35.7% 3.8%
PotashCorp (NYSE: POT  ) 20.1% 12.2% 36.7% 12%

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

Terra Nitrogen's returns on invested capital dwarf those of the other companies. While its returns are a great deal higher than they were five years ago, they have also fluctuated a great deal over the five-year period. Mosaic has the next highest returns, at almost 22%. While those returns are a great deal higher than they were five years ago, they have declined over the past three years. PotashCorp has returns not far behind Mosaic's, and while its returns are more than 8 percentage points higher than they were five years ago, they are still down since 2009.

Terra Nitrogen, along with its industry peers, has benefited from huge increases in stock prices, which means farmers have more money to spend on fertilizers and equipment. Terra Nitrogen also has been able to gain an advantage over some industry peers because of its ability to avoid using higher-priced mined goods such as potash, which allows it to keep its costs down.  

Terra Nitrogen has a huge dividend yield at 8.3%, which is well above Mosaic's 0.3% yield and PotashCorp's 1.2% yield. Terra Nitrogen's high yield is largely explained by its master limited partnership structure, which allows the company to direct its taxable income directly to shareholders instead of paying tax on that income.

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:

Jim Royal, Ph.D., owns no shares of any company mentioned here. 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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