Does CME Group Pass Buffett's Test?

Before you go, we thought you'd like these...
Before you go close icon

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 take a look at several companies in a single industry to determine their ROIC. Let's take a look at CME Group (NAS: CME) 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

The nuances of the formula are explained in further detail here. 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 four industry peers over a few periods.

CME Group4.4%3.5%2.9%20.1%
NYSE Euronext (NYS: NYX) 6.9%6.0%6.1%7.0%
Nasdaq OMX Group (NAS: NDAQ) 5.5%5.7%5.0%8.6%
CBOE Holdings (NAS: CBOE) 101.8%72.4%76.8%NA

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

CME's returns on invested capital are less than one-quarter of what they were five years ago. Two of the other listed companies have also seen declines over the same time period, but those declines were less drastic. CBOE Holdings, on the other hand, has increased its ROIC by 25 percentage points from three years ago.

However, after its big hit during the market downturn, CME's margins have steadily increased. There are also other reasons to find CME attractive. For example, because CME's clearinghouse is situated within the company, it has a competitive advantage over Nasdaq, as customers clear and settle their trades within CME. CME also runs the largest futures and options exchange in the world. The presence of these competitive advantages suggests CME's ROIC may continue to rise.

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. If you'd like to add these companies to your Watchlist, click below:

At the time this article was published Jim Royal, Ph.D., does not own shares of any company mentioned here.Motley Fool newsletter serviceshave recommended buying shares of NYSE Euronext. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not 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.

Read Full Story

Want more news like this?

Sign up for Finance Report by AOL and get everything from business news to personal finance tips delivered directly to your inbox daily!

Subscribe to our other newsletters

Emails may offer personalized content or ads. Learn more. You may unsubscribe any time.

From Our Partners