Does Coca-Cola 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 Coca-Cola (KO 0.36%) 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 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 Coke and three industry peers over a few periods.

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

While Monster Beverage's returns on invested capital are slightly lower than they were five years ago, its returns are the highest they've been in three years, and dwarf that of the other companies. Sustaining that level of return is quite a feat, suggesting that the company is maintaining its competitive advantage.

Coca-Cola has the next highest returns, but its ROIC has consistently declined significantly over the past three years, as the company took on some of its bottling operations. PepsiCo's ROIC is not far behind Coke's, but it has also seen consistent declines in its ROIC over the past five years, as it, too, took on some bottling operations. Dr. Pepper Snapple's returns are the lowest of these companies, but it is the only one whose current ROIC is higher than it was five years ago.

Coke offers many features that are attractive to conservative investors. It has cultivated a brand that most Americans recognize, and that has become a major part of American culture -- with Interbrand giving it the top ranking in world brands. Although it's no longer a high-growth company, it's still finding some growth by increasing its product offerings and extending its distribution into emerging markets. In fact, the company stated that it hopes to double its sales by 2020, with a strategy that includes focusing on emerging markets in Brazil, Russia, India, China, and the Middle East.

This stability and attractive ROIC have made Coke one of Buffett's long-term holdings.

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.