Does Union Pacific 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 Union Pacific (UNP 1.25%) 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.

Union Pacific and Canadian National Railway have comparable returns on invested capital close to the 10% range. But while Union Pacific has grown its ROIC significantly from five years ago, Canadian National Railway hasn't shown much growth. CSX offers returns on invested capital at nearly 8%, and while its returns are down from last year, they've increased from five years ago. Norfolk Southern offers returns on invested capital at exactly 7% -- the same as five years ago.

Union Pacific, Canadian National Railway, CSX, and Norfolk Southern have all suffered from a struggling economy, but high energy prices have helped them remain somewhat resilient as companies turn to cheaper methods for transporting their goods. Canadian National Railway and Union Pacific have also managed to gain significant advantages from insufficient pipeline coverage in North Dakota, which has forced energy companies to turn to them as a way to ship their energy from the Bakken Shale. Union Pacific's lack of heavy exposure to coal shipping has also helped shelter it from some of the revenue costs faced by CSX and Norfolk Southern, which have suffered from a reduced demand for coal.

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.