Does Pfizer Pass Buffett's Test?

We'd all like to invest as successfully as the legendary Warren Buffett. He calculates return on invested capital (ROIC) to help determine whether a company has an economic moat -- the ability to earn returns on its money beyond that money's cost.

ROIC is perhaps the most important metric in value investing. 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, ROIC divides a company's operating profit by the amount of investment it took to get that profit:

ROIC = Net operating profit after taxes / Invested capital

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 lands between 8% and 12%. Ideally, we want to see ROIC greater than 12%, at minimum. We're also seeking a history of increasing returns, or at least steady returns, which indicate that the company's moat can withstand competitors' assaults.

Let's look at Pfizer (NYSE: PFE) and two of its industry peers to see how efficiently they use capital. Here are the ROIC figures for each company over several time periods:

Source: Capital IQ, a division of Standard & Poor's. *The company declared a net loss for these periods.

Pfizer and Merck have not fared so well as of late, at least according to these ROIC figures. However, both have taken on significant acquisitions recently, with Pfizer acquiring Wyeth and Merck snapping up Schering-Plough. So those acquisitions seem to be causing some indigestion. Pfizer's ROIC is down from the year-ago period after climbing from five years ago. Merck also declined dramatically in the past year, displaying its lowest returns in the periods surveyed here. In contrast, Celgene has not made a multibillion-dollar purchase, and its ROIC has improved on five years ago.  The longer-term challenge for drug companies is, of course, maintaining a lucrative stream of cash from their blockbuster drugs, many of which are soon coming off patent.

Businesses with consistently high ROIC are efficiently using capital. They can use their extra returns to buy back shares, further invest in their future success, or pay dividends to shareholders. (Warren Buffett especially likes that last part.)

To unearth more successful investments, dig a little deeper than the earnings headlines, and check up on your companies' ROIC.

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