Does Tyson 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 Tyson Foods (NYS: TSN) 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 Tyson and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Tyson Foods10.9%12.9%2.6%0.2%*
Smithfield Foods (NYS: SFD) 10.3%7%2%**4.9%**
Sanderson Farms (NAS: SAFM) (14.7%)***20.6%(6.7%)***(3.7%)***
Hormel Foods (NYS: HRL) 16.3%14.8%11.5%13.2%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because TSN did not report an effective tax rate, we used its 32% rate from TTM.
**Because SFD did not report an effective tax rate, we used its 32% rate from TTM.
***Because SAFM did not report an effective tax rate, we used its 35% rate from one year ago.

Hormel Foods has the highest returns on invested capital of these companies, and it has increased its returns by a little over 3 percentage points from five years ago, a good sign. Tyson and Smithfield both have ROIC in the 10% range. Smithfield's returns have more than doubled from five years ago, and Tyson's current returns are much higher than their 0.2% ROIC from five years ago. Sanderson has returns on invested capital in the low negative numbers. Aside from a spike in its returns last year, it has offered increasingly lower returns over the past five years.

Tyson and its competitors are facing a tough environment for the sale of meat products because of increases in the price of feed. This increases the price of raising animals, which eats into profit margins. Worse, these profit margins were already pretty narrow, particularly for chicken, given oversupply problems.

While Tyson and its competitors could cut back production to address these problems, fellow Fool Dan Caplinger points out that Tyson, Sanderson Farms, and Pilgrim's Pride all refrain from doing so out of fear of losing market share. However, because the recent natural disasters in Japan crushed meat companies located there, American meat companies have the opportunity to export meat to consumers in Japan, which reduces the oversupply problem in the United States.

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. 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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