Does Silver Wheaton 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 Silver Wheaton (NYSE: SLW) 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 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 Silver Wheaton and three industry peers over a few periods.

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because Silver Wheaton did not report an effective tax rate, we used its 5% rate from three years ago.
**Because Agnico-Eagle Mines did not report an effective tax rate, we used its 23.6% rate from one year ago.

Silver Wheaton has by far the highest returns on invested capital of these companies and has seen consistent increases on its returns over the past three years. Its current returns are more than double the returns it had five years ago. Goldcorp has the second highest returns of these companies, but they're nearly 20 percentage points lower than Silver Wheaton's. However, the company has consistently grown its ROIC over the past five years. Yamana Gold has also consistently increased its returns over the past five years. Agnico-Eagle Mines has current ROIC in the low negative numbers, which are caused by its negative operating earnings.

Silver Wheaton's business model involves offering cash upfront to other mining companies for the right to later purchase their silver at low fixed costs. This model allows Silver Wheaton to gain more benefit from rising silver prices and allows miners such as Goldcorp to benefit from much-needed financing early on. Silver Wheaton also offers a modest 1% dividend.

Goldcorp has a pattern of aggressively acquiring new mining resources, which has allowed it to take advantage of the strong market for gold. In 2010, Goldcorp made a number of acquisitions, including Andean Resources (along with its Cerro Negro property), the Camino Rojo property, and a 70% interest in the El Morro project in Chile. The company's acquisition of the Cerro Negro property will help Goldcorp increase its gold production at low costs, putting Goldcorp in a particularly strong position to take full advantage of the bull market in gold. While Goldcorp's 1.1% dividend yield is modest, its ability to increase production, make smart acquisitions, and lower its costs speaks well of its ability to raise its yield in the future.

Yamana Gold also offers a dividend, at a 1.2% yield, and has grown its revenue in four out of the past five years. In addition, it is able to produce gold at lower costs than Barrick Gold and Goldcorp. One of the things that has allowed it to reduce its costs is the fact that one of its mines, the Chapada mine in Brazil, produces copper and other byproducts that bring in money that lower its overall expenses in producing gold.

In late October, Agnico-Eagle announced its decision to shut down its Goldex mine, which resulted in a 20% share-price decline on the day it was announced. However, the decision demonstrated that the company's leaders were unwilling to risk the lives of their underground personnel for the 1.6 million ounces of gold that remained in the mine, demonstrating the personal integrity of the company's leaders. Leaders made this decision after reports came back about new movement and weakness in the mine's rock, caused by the failure of the mine's hanging wall that caused groundwater to enter the mine. There are other reasons to like Agnico-Eagle: For one, the company owns a 9.2% stake in Rubicon Minerals. It also recently acquired Grayd Resource, which gave it access to some useful development assets. In addition, Agnico-Eagle offers a 1.8% dividend yield.

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.

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