Does Amazon.com 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, 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 Amazon.com (NAS: AMZN) 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

(You can read more about 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 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 Amazon and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Amazon.com21.5%56.4%49.9%94.4%
Overstock.com (NAS: OSTK) 19%*(97.3%)402.9%(41.5%)
eBay (NAS: EBAY) 12.3%15.6%23.7%12.3%
Blue Nile (NAS: NILE) (103.1%)(115.3%)(135.8%)(83.3%)

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because OSTK did not report an effective tax rate for TTM, we used its 16.5% effective tax rate from five years ago.

Amazon.com offers the highest returns on invested capital of the companies, but its current ROIC is less than a quarter of what it was five years ago. Blue Nile has put up a lot of negatives, but that's really reflecting its negative invested capital, which is a good place to be in for any business. Similarly, one year ago, Overstock had negative invested capital, but the negative five years ago represents negative operating profit after tax.

While Amazon's returns are higher than the other companies, the current difference between its returns and the returns of the other companies is nowhere close to the differences we saw five years ago, when Amazon's ROIC was only a few percentage points short of 100%. This suggests that Amazon may be running low on the most profitable opportunities.

However, Amazon has a strong track record for being innovative, which is an excellent way to find a new niche market and create a new competitive advantage. For example, Amazon.com recently moved into a new market against Netflix (NAS: NFLX) by offering free streaming video to its Amazon Prime subscribers. It's also well known for its Kindle and its new tablet, which is taking aim at Apple.

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. Feel free to 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 Apple.Motley Fool newsletter serviceshave recommended buying shares of Apple, Amazon.com, Netflix, Blue Nile, and eBay, writing puts in eBay, and creating a bull call spread position in Apple. 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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