Does Frontier Communications Pass Buffett's Test?http://www.fool.com/investing/dividends-income/2013/05/31/does-frontier-communications-pass-buffetts-test.aspx Jim Royal
May 31, 2013
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 Frontier Communications (NASDAQ: FTR) 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:
(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 Frontier and three industry peers over a few periods.
None of these companies meets our 12% threshold for attractiveness. Verizon comes the closest with an ROIC at 5.6%, but its returns have declined consistently over the past five years. Windstream's ROIC is also in the 5% range, but its returns are down by almost 7 percentage points. Frontier and Century Link have also seen serious declines in their returns. However, all of these companies offer significant dividend yields: Frontier Communications at 9.1%, Windstream at 11.5%, CenturyLink at 5.8%, and Verizon at 4%. However, investors should note that Frontier has cut its dividend twice over the past several years, and CenturyLink also cut its dividend recently. Windstream, on the other hand, has managed to maintain its payout -- at least for now.