Does Colgate-Palmolive 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 take a look at Colgate-Palmolive (NYSE: CL  ) 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

(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 Colgate and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Colgate-Palmolive 30.9% 34.1% 33.5% 27.6%
Clorox (NYSE: CLX  ) 19.1% 15.8% 17.8% 20.7%
Church & Dwight (NYSE: CHD  ) 12.5% 12.1% 9.6% 9.1%
Procter & Gamble (NYSE: PG  ) 10.2% 10.4% 10.5% 9.5%

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

Colgate-Palmolive has returns on invested capital more than 10 percentage points higher than the other companies. However, while its returns are slightly higher than they were five years ago, they are the lowest they have been in three years. Still, they sit at a very high level, suggesting a strong competitive position. Clorox has the second highest returns, but its ROIC is slightly lower than it was five years ago. Church & Dwight has steadily improved its returns on invested capital over the past five years, with current margins at 12.5%. Procter & Gamble has the lowest returns, which have not fluctuated by more than a percentage point over the five-year period.

One of the major reasons to own these household consumer-products companies is their growing and attractive dividends. In addition to offering appealing dividends, these companies have served as good defensive stocks during tough economic times because of the "must-have" nature of many of their products.

Colgate currently offers a 2.6% yield, Clorox 3.5%, Church & Dwight 1.9%, and Procter & Gamble 3.1%. Plus, each has managed double-digit gains in its dividend over the past five years. These companies have also consistently increased their dividends over the past 50 years, with Colgate's dividend increases -- 12.7% annually for the past half-decade -- looking even better than most of its industry peers.

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 no shares of any company mentioned here. The Motley Fool owns shares of Clorox. Motley Fool newsletter services have recommended buying shares of Unilever. The Motley Fool has a disclosure policy. We Fools don't 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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