Does Coca-Cola 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 Coca-Cola (NYS: KO) 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 Coca-Cola and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Coca-Cola15.1%22.3%20.5%22.3%
Hansen Natural (NAS: HANS) 76.5%60.9%59.9%130.9%
PepsiCo (NYS: PEP) 12.6%14%19.7%21.1%
Cott (NYS: COT) 9.4%8.9%0.6%*5.1%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because COT did not report an effective tax rate, we used its 31% effective tax rate from five years ago.

Coca-Cola's returns on invested capital have decreased by more than 7 percentage points from five years ago. Two of the other companies have also seen declines in their returns over the same time period, while Cott has drastically increased its returns.

Despite its decline in returns over the past five years, Coca-Cola provides several features that should be attractive to investors. Investing in a consumer-goods company like Coca-Cola with strong brand loyalty and growth opportunities in emerging markets can be a relatively safe bet, given the uncertain state of the current stock market. And those are reasons that Buffett, of course, owns shares of the company.

However, Coca-Cola's 2.9% dividend is lower than those offered by other giant beverage companies. For example, PepsiCo offers a 3.3% dividend and Dr Pepper Snapple (NYS: DPS) offers 3.6%.

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 Coca-Cola and PepsiCo.Motley Fool newsletter serviceshave recommended buying shares of Hansen Natural, Coca-Cola, and PepsiCo and creating a diagonal call position in PepsiCo. 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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