Does IBM 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 IBM (NYS: IBM) 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

IBM23.6%22.1%16.0%13.3%
Qlik Technologies (NAS: QLIK) 148.2%(279.8%)N/AN/A
Actuate (NAS: BIRT) 23.9%27.3%20.3%*39.9%
MicroStrategy (NAS: MSTR) 64.4%882.9%549.7%111.7%

Source: S&P Capital IQ. TTM=trailing 12 months. * Because BIRT did not report an effective tax rate, we used its 28% effective tax rate from one year ago.

IBM's returns on invested capital are the lowest of the listed companies, but they show the kind of steady growth we like to see. But they're still at a very attractive level. Do not be alarmed by the low negative ROIC produced by Qlik last year, since this is a result of its negative invested capital, which is a good position for any company to be in. It also produced very high returns this year. MicroStrategy has the next highest returns, reaching nearly 65%, but those are the lowest returns it has produced in the last five years, as its invested capital has grown. Actuate also has much lower returns than it produced five years ago, though its ROIC is still quite attractive.

While IBM is best known for its hardware, it has increasingly offered software and services that can be used with that hardware. This has helped IBM increase its margins over time and create a competitive advantage against other hardware companies such as Hewlett-Packard (NYS: HPQ) , Dell (NAS: DELL) , and Oracle (NAS: ORCL) . IBM also has more exposure to international markets than its industry peers, with nearly two-thirds of its revenue coming from outside the Americas.

Finally, IBM has been steadily raising its dividend, now at 1.7%, for 15 years. The other companies listed in the table do not offer a dividend at all. It's for reasons like these that Buffett has actually taken a stake in Big Blue.

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.The Motley Fool owns shares of International Business Machines, Oracle, and Qlik Technologies.Motley Fool newsletter serviceshave recommended buying shares of Qlik Technologies and Dell. 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.

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