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Does Apple 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 Apple (Nasdaq: AAPL  ) 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 Apple and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Apple 44.2% 45.7% 268.4% 838.5%
Dell (Nasdaq: DELL  ) 36.4% 51.5% 97.2% (92.2%)
Hewlett-Packard (NYSE: HPQ  ) 10.4% 15.2% 14.3% 15.6%
Seagate Technology (NYSE: STX  ) 26% 36.8% 16.4% 8.1%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because Seagate did not report an effective tax rate, we used its 15.4% rate from five years ago.

Apple has the highest returns on invested capital of the companies, but its returns have been steadily declining over the five-year period. Dell has the next highest returns, but it's seen steady and significant declines over the past three years because of its diversification into some services businesses. And that negative number five years ago? That was when Dell had negative invested capital, an enviable position to be in.

Seagate Technology has returns above 25% and has grown those returns significantly from five years ago, but they have declined more than 10 percentage points since last year. Hewlett-Packard has the lowest returns of the companies, and its current returns are the lowest they've been in five years.

Apple's dominance in the tablet market has served it well. Not only are tablets extremely popular for personal use, but people are also increasingly using them for business purposes. Data from Forrester Research suggests that businesses will buy around \$10 billion worth of iPads in 2012. However, with Dell creating a new line of its own tablets, Apple faces some threats in this area, since Dell has a track record of catering to businesses by using its long-standing relationships with business clients to customize products to fit their interests. Dell's systems also tend to be more compatible with the complex systems in businesses than are Apple systems. So while Apple holds the lion's share of the market now, there's no guarantee that it always will.

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. The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of Apple, creating a bull call spread position in Apple, and writing covered calls on Dell. 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.

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

• Report this Comment On April 07, 2012, at 9:08 PM, H3D wrote:

That's the same logic as to why Dell's previous tablet would work for business. Dell canned it when it didn't.

• Report this Comment On April 08, 2012, at 2:24 PM, applefan1 wrote:

The problem with Dell's ecosystem is that they don't really control it. The only thing they do is create the hardware, use someone else's OS, and they're supposed to support both. That model doesn't work well, since they didn't create the OS. Apple's ecosystem is far more advanced than the competition, they have far more control and innovate. Which is why everyone is trying to copy what they can, but the ecosystem is what is going to make or break a platform. Fragmented ecosystem, fragmented business model. By the time Dell catches up to Apple, Apple will be further along. The solution is how good is the ecosystem, hardware leapfrogs back and forth but if the ecosystem isn't there, then the solution isn't there.

• Report this Comment On April 09, 2012, at 4:49 AM, BWinski wrote:

IF you actually believe Dell has any chance - AT ALL of putting a dent in Apple's trajectory over the next five years, you have become a serious drug abuser and the delusion phase has kicked into over-drive...

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Jim Royal
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Jim is a special-situations investor focusing on transactional events (such as spinoffs, recapitalizations, or reorganizations, among others) that create advantageous stock mispricings.

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