Does Analog Devices 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 take a look at several companies in a single industry to determine their ROIC. Let's take a look at Analog Devices (NYS: ADI) 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.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Analog Devices74.2%72.5%40.9%35.9%
Cypress Semiconductor (NAS: CY) 37.7%20.8%(3.2%)0.3%
Linear Technology (NAS: LLTC) 110.8%106.6%96.9%117.2%
ON Semiconductor Corp. (NAS: ONNN) 15.3%24.1%12.8%*30.0%*

Source: S&P Capital IQ. TTM = trailing 12 months. *Because ONNN did not report an effective tax rate, we used its 17.4% rate from TTM.

All of the listed companies have high returns on invested capital, with Cypress Semiconductor and Analog Devices both showing dramatic growth in their returns from five years ago, suggesting that their competitive positions have improved. Linear Technology and ON Semiconductor, on the other hand, have lower margins than they did five years ago, although Linear's still sit at very attractive levels.

Analog Devices creates integrated circuits that help convert light, sound, and other inputs into electrical signals. These circuits are used in a wide range of industries, including health care, aerospace, and automotive.

Now that Texas Instruments made a deal to take over National Semiconductor, some other large industry peers may be interested in following suit. Analog has a number of options that would make a logical fit, including Intersil (NAS: ISIL) , Linear Technology, or ON Semiconductor.

Finally, Analog offers a nice dividend yield at 2.8%, which outperforms Cypress Semiconductors' 1.9% dividend yield. However, Linear Technology offers the highest dividend yield of its listed industry peers at 3.1%.

With a healthy dividend that's unusual for tech companies, reasonable valuation, and strong financial performance, Analog Devices is worth a closer look. It may fall a point short of perfection, but it could be exactly the stock your portfolio needs to thrive.

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

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