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 take a look at Coca-Cola (KO -0.52%) 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 Coca-Cola and three industry peers over a few periods.

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

Coca-Cola's returns on invested capital are around the lowest they have been in the past five years, as are Pepsico's. While Dr Pepper Snapple has the lowest returns on invested capital of the listed companies, it managed to gradually grow its returns over the past five years. SodaStream has the highest returns of the listed companies, but its current returns are about 3 percentage points lower than they were three years ago. Still, their high level suggests the company is maintaining its competitive advantage.

All of these companies have struggled to deal with the slow-growing soft-drink market in the U.S. Larger companies like Coca-Cola and Pepsi have tried to fill this void by expanding into emerging markets like China and India, which have a growing middle class that can spare the change for affordable luxuries like soft drinks. While Coke has benefited from its powerful brand, it still suffered a 4% sales volume decline at the end of 2012 while Pepsi managed to seize some market share.

Also, Coke and Pepsi continue to face domestic competition from smaller players like SodaStream and Dr Pepper Snapple. In particular, they should pay attention to SodaStream's ability to form strategic partnerships with much larger companies that are in a strong position to help the company promote its products.

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.