Does Colgate-Palmolive Pass Buffett's Test?

We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.

In this series, we examine several companies in a single industry to determine their ROIC. Let's take a look at Colgate-Palmolive (CL -0.05%) and three of its industry peers, to see how efficiently they use cash.

Of course, it's not the only metric in value investing, but ROIC may be the most important one. 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, it divides a company's operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / Invested capital

(Get further detail on the nuances of the formula.)

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 it 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 between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Here are the ROIC figures for Colgate and three industry peers over a few periods.

Source: S&P Capital IQ. TTM=trailing 12 months.

Colgate-Palmolive has returns on invested capital more than 10 percentage points higher than the other companies. However, while its returns are slightly higher than they were five years ago, they are the lowest they have been in three years. Still, they sit at a very high level, suggesting a strong competitive position. While the company has the potential to profit from its growth in emerging markets, increasing raw materials costs have eaten into its margins.

Clorox has the second highest returns, but its ROIC is more than three percentage points lower than it was five years ago. Church & Dwight's returns are slightly higher than they were five years ago, but are the lowest they've been in three years. Procter & Gamble has the lowest returns of the listed companies, and while its returns are almost a percentage point higher than they were five years ago, they are at a three-year low.

One virtue shared by all of these consumer-products companies is their resilience during tough economic times. While they don't have the same growth potential as many other types of stocks, consumer reliance on their products remains constant. These companies also tend to offer growing and attractive dividends, which offer investors a reliable income even if the underlying stock price suffers.

Colgate currently offers a 2.4% yield, Clorox 3.5%, Church & Dwight 1.8%, and Procter & Gamble 3.3%. Plus, each has managed double-digit gains in its dividend over the past five years, with Colgate's dividend increases -- 12% annually for the past half-decade -- looking even better than most of its industry peers. Church & Dwight has offered even higher increases, with a five-year average of 44%.

Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.