Does CVS Caremark 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 CVS Caremark (NYS: CVS) 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

(Get further detail nuances on 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 it 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 CVS and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

CVS Caremark7.3%7.3%7.6%9%
Walgreen (NYS: WAG) 14.2%13.7%13.2%17%
Rite Aid (NYS: RAD) 4.1%*2.4%*1.7%*4.4%*
Wal-Mart (NYS: WMT) 13.4%14.3%13.4%13.1%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because RAD did not report an effective tax rate, we used a 35% effective tax rate.

Walgreen has the highest returns on invested capital of these companies, but those returns are down almost 3 percentage points from five years ago. Wal-Mart is a close second. Aside from the small spike in its returns last year, it has maintained fairly consistent returns over the five-year period. CVS has just over half the current ROIC of Walgreen, and its ROIC has gradually declined over the past five years. Rite Aid's returns on invested capital are far lower than that of the other companies, but after a sharp decline three years ago, it has seen steady increases in its ROIC over the past three years.

CVS has shown some good growth over the past few years, and unlike Rite Aid, it has kept its debt levels reasonable. Also, after Medco Health was investigated for possible improprieties, CVS took over the CalPERS public-employee pharmacy benefits management business. CVS has also grown its health-care benefit division by buying Universal American's Medicare Part D business. Going forward, CVS faces the challenge of finding ways to continue winning contracts in the face of a likely merger between Medco and Express Scripts, which could eat into CVS's market share.

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 Wal-Mart Stores.Motley Fool newsletter serviceshave recommended buying shares of Wal-Mart Stores and Medco Health Solutions and creating a diagonal call position in Wal-Mart Stores. 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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