Do These Supermarkets 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 is from 8% to 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 Safeway (NYSE: SWY) 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. * Uses 2008's effective tax rate of 35.8%. ** Uses 2008's effective tax rate of 36.5%. *** Uses the trailing 12 months effective tax rate of 39.5%.

Well, there's nothing special in these supermarkets' shelves. Mid- to high-single-digit ROICs are not particularly attractive and there's little evidence that this situation will change. Still, Kroger has managed to break into double digits. Safeway floats around the 7% to 8% range, while SUPERVALU has recently come in around 6%. ROICs for these supermarkets are subpar, but the best of the blue chip retailers -- which earn superior ROICs to grocers -- want to move into groceries.

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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