Does SanDisk Pass Buffett's Test?

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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 (ROIC) to help determine whether a company has an economic moat -- the ability to earn returns on its money above 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, ROIC divides a company's operating profit by how much investment it took to get that profit. The formula:

ROIC = Net operating profit after taxes / Invested capital

(We have more details on this formula, if you're curious.)

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%. We prefer to see ROIC above 12% at a minimum, along with a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Let's look at SanDisk (NAS: SNDK) and three of its industry peers, to see how efficiently they use cash. Here are the ROIC figures for each company over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

SanDisk22.9%30.8%1.7%17.3%
STEC (NAS: STEC) 29.6%53.8%3.5%6.5%
Seagate Technology (NAS: STX) 22.9%53.7%*23.0%16.6%
Western Digital (NYS: WDC) 27.9%52.7%41.7%59.9%**

Source: Capital IQ, a division of Standard & Poor's.
*Because STX did not report an effective tax rate, we used its 11.7% tax rate from TTM.
**Because WDC did not report an effective tax rate, we used its 11.6% effective tax rate from three years ago.

The ROIC looks pretty good in this generally competitive sector.  SanDisk's returns on invested capital are up several percentage points from five years ago, but those returns have fluctuated over the five-year period and are down significantly from last year. STEC and Seagate have shown similar growth over the five-year period, with similar fluctuation over the same period. Western Digital is the only company whose returns are lower currently than they were five years ago.   

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. Warren Buffett has long loved healthy and growing dividends -- and you should, too.

So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. If you'd like, you can add these companies to your Watchlist.

At the time this article was published Jim Royal, Ph.D., owns no shares of any company mentioned here. The Motley Fool owns shares of Western Digital. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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