Does Boston Scientific 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 Boston Scientific (NYS: BSX) 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

(Read more on 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 Boston Scientific and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Boston Scientific4.2%4%4.2%4.8%
CR Bard (NYS: BCR) 23%23.4%*22.2%*23.3%
AngioDynamics (NAS: ANGO) 5.2%4.6%4.5%13.4%
Hologic (NAS: HOLX) 4.4%4.6%**3.8%**5%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because BSX did not report an effective tax rate, we used its 26% rate from TTM.
**Because HOLX did not report an effective tax rate, we used its 31% rate from TTM.

CR Bard has the highest returns on invested capital of these companies and has maintained fairly consistent returns over the past five years, a very good sign. Meanwhile, Boston Scientific, AngioDynamics, and Hologic have seen more fluctuation and greater overall declines in their ROIC. CR Bard also offers a 0.9% dividend yield while Boston Scientific, Angio Dynamics, and Hologic fail to offer a dividend at all.

Boston Scientific produces a wide range of medical devices, including stents, heart defibrillators, and catheters. Its competition includes the companies in the list as well as those with similar product offerings, including Abbott Labs, St. Jude Medical, and Medtronic. While it has succeeded in bringing on the former chairman of Johnson & Johnson's medical-device group, Michael Mahoney, a non-compete clause prevents him from serving as Boston Scientific's CEO until late 2012. The company will therefore have to use an interim CEO for a little more than a year, making the transition rockier. Boston Scientific is likely to benefit from Johnson & Johnson's decision to stop selling drug-eluting stents, but it will continue to face competition from Medtronic and Abbott Labs in that area.

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 Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson, St. Jude Medical, Medtronic, and Abbott Laboratories.Motley Fool newsletter serviceshave recommended buying shares of Johnson & Johnson and Abbott Laboratories. 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.

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