Do These Casinos 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 Las Vegas Sands (NYSE: LVS) 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. * Tax rate normalized to 35%, since erratic tax rates made the company's ROIC look negative even when it recorded operating earnings. ** Uses 2007's effective tax rate of 35%. *** Uses 2007's effective tax rate of 34.6%.

The casino industry has gone on a building binge in the past decade, and when the economy craps out, it should be little surprise that casinos get hurt. They're stuck with investments in buildings whether the times are good or bad, so we should see fluctuating returns, as we do above. Five years ago, the picture looked much better for these companies, but if you think the economy will turn, then it might be a good time to pick up some casino stocks. Still, their low ROICs make them less attractive, and none hits our desired threshold.

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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