Does Transocean 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 Transocean (NYSE: RIG  ) 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 Transocean and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Transocean 1.3%* 6.1% 15.1% 10.6%
Ensco (NYSE: ESV  ) 4.1% 9.6% 22.8% 22.2%
Nabors Industries (NYSE: NBR  ) 4.4% 3%** 10% 13.4%
Diamond Offshore Drilling (NYSE: DO  ) 19.3% 19.8% 36.6% 23.2%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because Transocean did not report an effective tax rate, we used its 26% rate from one year ago.
**Because Nabors did not report an effective tax rate, we used its 29.4% rate from TTM.

Diamond Offshore Drilling has current returns on capital that dwarf that of the other companies, but it has seen steady declines in its ROIC over the past three years. Ensco also shows declining returns from the boom years. Nabors Industries' current returns are up from last year, but they declined steadily before that and are currently less than a third of what they were five years ago. Transocean's current returns are less than 2% and have also steadily declined over the past three years.

Transocean has had no shortage of challenges over the past few years. For starters, BP (NYSE: BP  ) has made moves in an attempt to get Transocean and Halliburton to pay it back for some of its huge expenses in cleaning up the Gulf of Mexico oil spill. Transocean has also recently failed to compete with the performance of its industry peers. The company blames new regulations for its recent performance. However, competitors including SeaDrill have seen sales and profits rise in the face of these new regulations.

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. You can also add these companies to your Watchlist:

Jim Royal, Ph.D., owns no shares of any company mentioned here. The Motley Fool owns shares of Transocean and Ensco. Motley Fool newsletter services have recommended buying shares of SeaDrill. 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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