Does Capstone Turbine 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 Capstone Turbine (NAS: CPST) 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

Capstone Turbine(75.1%)*(68%)*(97.9%)*(185%)*
Cummins (NYS: CMI) 23.6%13.9%14.9%15.8%**
Briggs & Stratton (NYS: BGG) 6.1%5.8%1.8%6.1%
Navistar International (NYS: NAV) 5.2%***8.5%6.3%6.9%

Source: S&P Capital IQ. TTM = trailing 12 months. *Because CPST did not report an effective tax rate, we used a 35% rate. **Because CMI did not report an effective tax rate, we used its 32.5% rate from three years ago. ***Because NAV did not report an effective tax rate, we used its 24% rate from five years ago.

Capstone Turbine is looking pretty rough, with returns on invested capital well into the negative numbers due to negative earnings before interest and taxes. However, it has shown some improvement from five years ago. All of the other listed companies have returns above 5%, with Cummins offering returns above 23%, suggesting that it has gained competitive position over the last few years.

Capstone brought in a lot of interest around 2005 when Jim Cramer recommended it as a play in alternative energy and because of a report that Wal-Mart would buy a large number of Capstone's turbines. At that time, the company also had a strong working relationship with United Technologies.

Despite this early promise, Capstone has consistently failed to turn a profit, and is burning through cash at high rates. Given this huge string of losses, it's almost amazing that investors continue to fund the company.

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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