Do These Coal Miners Pass Buffett's Test?

We'd all like to invest as successfully as the legendary Warren Buffett. He calculates return on invested capital 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 Peabody Energy (NYSE: BTU) 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. TTM = 12 trailing months. *Uses TTM effective tax rate of 25.2%.       **Uses a tax rate of 25.2% for comparison purposes, since no effective rate was provided for these periods. ***Uses 2006's effective tax rate of 20.4%.

Don't expect sustainably high ROIC in a commodity product such as coal. Peabody Energy's returns on invested capital have fluctuated over the past five years, befitting the volatile nature of its product. CONSOL Energy has had even lower ROIC, and shows declines in its returns from three years ago. In figuring Arch Coal's ROIC, I had to estimate a tax rate since an effective rate was not provided for any of these periods. For the sake of comparison, I chose a 25.2% rate, which was about what Peabody paid in several periods. At that rate, Arch consistently comes in at the bottom of this trio. If you're looking for more stable returns on invested capital, then you should have a look at blue-chip consumer companies.

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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