Does Amgen 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 Amgen (Nasdaq: AMGN  ) 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 Amgen and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Amgen 20.5% 22.4% 20% 16.8%
Celgene (Nasdaq: CELG  ) 22.1% 15.6% 15.4%* 24.9%
Biogen (Nasdaq: BIIB  ) 20.3% 19.3% 13.5% 4.6%
Gilead Sciences (Nasdaq: GILD  ) 59.7% 39.8% 50.5% 50.6%**

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because Celgene did not report an effective tax rate, we used its 13% rate from one year ago.
**Because Gilead Sciences did not report an effective tax rate, we used its 26% rate from three years ago.

Gilead Sciences has returns on invested capital nearly 3 times higher than the other companies, all of which are good in their own right. Gilead's current returns are also more than 9 percentage points higher than they were five years ago. Amgen and Biogen have returns in the 20% range. While Amgen has shown some growth from five years ago, Biogen has grown its ROIC by more than 15 percentage points. Celgene puts up comparable numbers, but its returns are down from five years ago, though they've rebounded from the mid-teens three years ago.

Amgen's steady returns have allowed it to start returning money to investors through dividends, with a current yield of 2.2%. This distinguishes it from other profitable biotechs like Gilead, which is using its money to make strategic acquisitions. However, even as Amgen pays dividends to its shareholders, it is still leaving some money to make some strategic acquisitions of its own. In February, Amgen announced its decision to buy Micromet for $1.16 billion.

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 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. Motley Fool newsletter services have recommended buying shares of Gilead Sciences. 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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