Does Whole Foods 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 Whole Foods (NAS: WFM) 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 find out 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 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 Whole Foods and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Whole Foods12.5%9.7%5.7%14.3%
SUPERVALU (NYS: SVU) 2.7%6.6%*6.2%2.6%
Safeway (NYS: SWY) 6.7%7.1%**8.6%7.8%
Kroger (NYS: KR) 9.7%9.2%10.1%9.6%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because SVU did not report an effective tax rate, we used its 38.7% rate from three years ago.
**Because SWY did not report an effective tax rate, we used its 37.3% rate from three years ago.

Whole Foods' returns on invested capital are the highest of its industry peers, but they are down almost 2 percentage points from five years ago. However, after falling sharply three years ago, the company's returns have steadily increased. SUPERVALU's returns on invested capital are the lowest of its industry peers. Its ROIC is slightly higher than it was five years ago but less than half of what it was three years ago or last year. The other listed companies have also either seen a lack of growth or declines in their ROIC. The grocery sector is tough.

In 2008, when Whole Foods suffered from the drastic declines in its ROIC, it had to temporarily suspend its dividend. Although the company has since restored the payout, it offers only a 0.9% yield. SUPERVALU, on the other hand, offers a 4.7% yield, Safeway offers a respectable 2.8% yield, and Kroger offers a 1.9% yield.

However, while its industry peers have had difficulty maintaining current sales, Whole Foods has consistently grown its revenues and profits. It has also created an interest in organic foods that has caused more traditional supermarkets to offer more organic options in a bid to compete.

Businesses with consistently high ROIC show that 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. Add these companies to your Watchlist:

At the time this article was published Jim Royal, Ph.D., owns shares of SUPERVALU The Motley Fool owns shares of Whole Foods Market and SUPERVALU.Motley Fool newsletter serviceshave recommended buying shares of Whole Foods Market and buying calls in SUPERVALU. 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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