Do These Electronics Companies 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 Tyco Electronics (NYSE: TEL) 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 TTM effective tax rate of 27.5%. **Uses data for the year ended September 2005. ***Uses 2005’s effective tax rate of 14.6% for comparison purposes.  ****Uses effective tax rate of 35.4% for year ended June 2008.

Tyco is the best performer of this motley crew, although the table doesn’t fully indicate as much. In fact, three years ago, Tyco had an effective tax rate of nearly 300%, which seriously dented its returns for that period, as you can imagine. If you simply normalized the rate to 27.5%, then Tyco puts up a 7.6% ROIC -- right in line with its prior performance. Alcatel-Lucent's ROIC seems to have flatlined around 0, while Molex has clawed back ground that it lost a year ago. None of these companies meets our 12% threshold for attractiveness, let alone consistently.

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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