Does Priceline.com 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 look at priceline.com (BKNG -0.51%) 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.

*Because PCLN did not report an effective tax rate for three years ago or five years ago, we used its 22% effective tax rate from last year.
**Because OWW did not report an effective tax rate for any of the years, we used a 22% effective tax rate.
Source: S&P Capital IQ. TTM=trailing 12 months.

Priceline.com has extremely high returns on invested capital that dwarf those offered by the other listed companies. It has also managed to consistently grow its returns over the past five years. Operating profit has skyrocketed while invested capital has been severely cut -- the exact formula you want to see.

Expedia has also consistently grown its ROIC over the past five years, but its returns are only a small fraction of those offered by Priceline. While Expedia's current returns are much higher than they were five years ago, they're down from last year. Ctrip.com's returns on invested capital are the lowest of the listed companies, and its returns have consistently declined over the past five years as invested capital soared. ROIC at Orbitz finally seems to have perked up after year of malaise.

Priceline has grown impressively over the past few years and has remained resilient as consumer spending has decreased because of the recession. Part of its resilience may be attributed to its extension into international markets, in which it has seen considerable success. In fact, Priceline has even managed to compete effectively in China against Ctrip as it works to take advantage of the growing middle class there. Priceline also managed to negotiate a partnership with Ctrip that gives both companies access to the 235,000 hotels listed in Booking.com.

On the domestic front, Priceline's acquisition of Kayak may help it compete more effectively with Expedia, Orbitz, and TripAdvisor because of the access to consumer data it gained through Kayak.

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.