Does PG&E 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

(You can read more 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%. 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 PG&E (NYS: PCG) 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

PG&E3.4%4%4.4%4.7%
Edison International (NYS: EIX) 3.3%4.3%5%5.7%
Sempra Energy (NYS: SRE) 4.9%4.7%4.7%7.9%
Exelon (NYS: EXC) 5.7%6.6%7.7%1.8%

Source: S&P Capital IQ.

PG&E's returns on invested capital have steadily declined over the past five years, as have Edison International's. Sempra's returns have shown a similar downward trend over the same time period, while Exelon's ROIC is up by almost 4 percentage points from 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. 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. Add these companies to your Watchlist:

At the time this article was published Jim Royal, Ph.D., owns shares of Exelon.Motley Fool newsletter serviceshave recommended buying shares of and creating a write covered strangle position in Exelon. 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.

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