Does UnitedHealth Group 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, 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.

In this series, we examine several companies in a single industry to determine their ROIC. Let's take a look at UnitedHealth Group (NYS: UNH) 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 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 get further details 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%. 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 UnitedHealth and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

UnitedHealth Group18.9%15.9%15.4%20.2%
WellPoint (NYS: WLP) 16.8%16%11.7%9.9%
Cigna (NYS: CI) 4.9%4.1%3%3.4%
Aetna (NYS: AET) 7.9%6.7%6.4%7.2%

Source: S&P Capital IQ. TTM=trailing 12 months.

UnitedHealth Group offers higher returns on invested capital than the other companies, but its current returns are lower than they were five years ago. However, after a sharp decline three years ago, UnitedHealth has steadily increased its returns. The other companies have seen at least slight gains in their ROIC over the past five years.

As recent reforms tighten regulations on health-care providers, the competitive landscape among these providers is changing rapidly. For example, now that providers are no longer allowed to deny coverage to individuals with pre-existing conditions, the success of these companies depends on their ability to sell health-care plans to healthy people to cover their losses among those dealing with severe health issues. In addition, now that providers are required to pay minimum amounts to cover claims, they face pressure to find other ways to cut costs.

The fact that UnitedHealth's return on invested capital is lower than it was five years ago is not necessarily a reason to despair. Other than the fact that its returns have increased since the decline three years ago, there are other reasons to be attracted to this stock. For example, despite the pressures coming with rapid health-care reform, UnitedHealth has substantially increased its dividend over the past two years and now yields 1.3%.

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 UnitedHealth Group.Motley Fool newsletter serviceshave recommended buying shares of UnitedHealth Group and WellPoint and creating a diagonal call position in UnitedHealth Group. 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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