Does Honeywell 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 Honeywell International (HON 0.38%) 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 Honeywell and three industry peers over a few periods.

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

*Because Exide Technologies did not report an effective tax rate for any of the listed years, we used a 25% rate.

Both Honeywell and BorgWarner meet our 12% threshold for attractiveness. But while BorgWarner shows significant growth in its returns from five years ago, Honeywell's returns are roughly the same as they were then. Johnson Controls' and Exide's returns are less than half of our 12% threshold, and both offer lower current returns than they had five years ago.

In 2012, Honeywell benefited from its exposure to some of the most resilient areas of a struggling economy. This year, the company is likely to suffer from the possibility that one of its largest clients, Boeing, will not be able to meet its commitments due to labor disputes and problems with its 787 Dreamliner. However, Honeywell does have other clients, including Textron, that may help cushion any hits associated with cuts in demand from Boeing.

Johnson Controls is involved in both the building control and HVAC market and in the auto components market. Johnson controls serves some of the biggest automobile companies, including Ford and General Motors. However, as the competitive position of these companies weakens, Johnson Controls needs to find new growth opportunities. While the company tried to improve its competitive position through the acquisition of A123 Systems' assets, it lost out to Chinese company Wanxiang America. While this failed bid may have been bad for Johnson Controls, it was good for Exide, which will not suffer from the competitive advantages Johnson would have gained through this acquisition.

Like Johnson Controls, BorgWarner also benefits from its relationship with large automobile companies like Ford. However, it also faces pressure to continue offering the best technological innovations and keeping costs down in order to maintain its supplier relationship with these companies.

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.