Does AT&T 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 AT&T (NYSE: T  ) 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

AT&T 4.2% 5.6%* (0.5%)* 2.9%
Sprint Nextel 0.4%** (0.9%)** (1.2%)** 2.3%
Verizon Communications 9.6% 8.1% 8.7%*** 7.0%
Vodafone Group 4.2% 3.6%**** 4.8% 5.5%****

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because AT&T did not report an effective tax rate, we used its 32% rate from 5 years ago.
**Because Sprint Nextel did not report an effective tax rate, we used its 32% rate from 5 years ago.
***Because Verizon did not report an effective tax rate, we used its 19.4% rate from 3 years ago.
****Because Vodafone did not report an effective tax rate, we used its 27.8% rate from 3 years ago.

Verizon (NYSE: VZ  ) has the highest returns on invested capital of the listed companies, at close to 10%, and has grown its ROIC from five years ago. Vodafone (Nasdaq: VOD  ) and AT&T both offer 4.2% returns on invested capital, but while AT&T has improved its returns from five years ago, Vodafone's returns are down. Sprint Nextel (NYSE: S  ) has returns below 1%, and while it has improved its ROIC over the past three years, its current returns are lower than they were five years ago.

AT&T's earnings have suffered recently due to a $4.2 billion charge imposed on the company for failing to complete its planned merger with T-Mobile. The company now needs to find a way to pick up more wireless spectrum to support the increased demand for its 4G service. While some have speculated that the company may try to buy some spectrum from MetroPCS or DISH Network, the latter has expressed interest in starting its own wireless network. However, AT&T continues to benefit from strong iPhone sales, and Frontier Communications' agreement to resell AT&T wireless services offers some hope of future growth.

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., owns shares in Frontier, AT&T, and Vodafone. Motley Fool newsletter services have recommended buying shares of Vodafone Group. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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