Does Service Corp. 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) in order 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, 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

The nuances of the formula are explained in further detail here. 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 efficient 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.

Let's take a look at Service Corp. (NYS: SCI) 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

Service Corp.2.4%2.4%2.8%2%
Stewart Enterprises (NAS: STEI) 2.5%2%2.3%2.3%
Stonemor Partners (NAS: STON) 0.7%*1.2%*1.6%1.8%
Hillenbrand (NYS: HI) 11.5%25.6%22.8%45.7%

Source: Capital IQ, a division of Standard & Poor's.
*Because Stonemor did not report an effective tax rate, we used its 13% effective rate from three years ago.

With the exception of Hillenbrand, the ROICs here look substandard. Service Corp.'s returns are slightly down from three years ago, suggesting that its competitive position is growing weaker. Only Hillenbrand looks like it has decent returns, and those have slipped greatly from prior periods.

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.

So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. If you'd like to add these companies to your Watchlist, or set up a new Watchlist, just click here.

At the time this article was published Jim Royal, Ph.D., does not own shares of any company mentioned here. The Motley Fool owns shares of Hillenbrand and Stonemor.Motley Fool newsletter serviceshave recommended buying shares of Hillenbrand. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not 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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