Does Crocs 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 Crocs (NAS: CROX) 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 Crocs and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Crocs35.7%21.6%(10.7%)*48.1%
Cherokee (NAS: CHKE) 56.2%109.9%136.5%188.5%
Skechers USA(2.4%)**22.3%15%19.5%
Quiksilver(67.9%)***(6.1%)8.3%6%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because CROX did not report an effective tax rate, we used its 16.4% rate from one year ago.
**Because SKX did not report an effective tax rate, we used its 32% rate from one year ago.
***Because ZQK did not report an effective tax rate, we used its 33% rate from three years ago.

Cherokee has the highest returns on invested capital of these companies but has seen steady declines in those returns over the past five years, something to be concerned about. Crocs saw a sharp decline in its ROIC three years ago but has steadily improved the figure since that point, an encouraging sign. Shechers and Quiksilver have also seen drastic reductions in their ROIC from five years ago.

In 2006, Crocs earned 62% of its revenue from its classic namesake rubber shoes, which caused the company's epic collapse when the popularity of those shoes waned. After that, the company began to search for products that were less dependent on the most current trends. To that end, it has developed a new line of shoes that it's marketing to golfers, and another that it is marketing to back-to-school shoppers.

However, with lots of competition from Nike, Deckers Outdoor, and Under Armour in addition to the competitors I've mentioned, Crocs has no shortage of work to do in winning consistent sales.

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. Add these companies to your Watchlist:

At the time this article was published Jim Royal, Ph.D., owns no shares of any company mentioned here. The Motley Fool owns shares of Under Armour.Motley Fool newsletter serviceshave recommended buying shares of Skechers USA, Under Armour, Deckers Outdoor, and Nike and creating a diagonal call position in Nike. 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 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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