Does Abbott Laboratories 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 Abbott Laboratories (NYS: ABT) 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

(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 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 Abbott and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Abbott Laboratories18%13%15%13.8%
Sanofi (NYS: SNY) 7.3%8.5%8.8%6.4%
Bristol-Myers Squibb (NYS: BMY) 29.6%28%23.7%15.8%
Novartis (NYS: NVS) 11.6%9.9%12.1%13.3%

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

Abbott Laboratories has increased its returns on invested capital by more than 4 percentage points from five years ago. Bristol-Myers Squibb shows more dramatic growth, with an increase of almost 14 percentage points over the past five years, while Novartis has seen slight declines in its returns.

Abbott's growth has primarily depended on a single drug, Humira. While this may be cause for worry, Abbott has announced a plan to split itself into two publicly traded businesses -- one focusing on pharmaceuticals and the other focusing on medical devices. This will put the resulting companies in a stronger position to compete against other companies in their niche markets, including Merck (NYS: MRK) , Pfizer (NYS: PFE) , and Medtronic (NYS: MDT) .

In addition, long-term investors should be attracted to Abbott's continued devotion to increasing its dividend. The company currently yields a solid 3.5%.

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 Medtronic and Abbott Laboratories.Motley Fool newsletter serviceshave recommended buying shares of Novartis, Abbott Laboratories, and Pfizer. 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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