Does H.J. Heinz 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 H.J. Heinz (NYS: HNZ) 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

H.J. Heinz14.0%15.6%14.5%11.6%
J&J Snack Foods12.9%16.0%11.1%14.4%
ConAgra Foods9.9%8.5%7.3%9.0%
Sara Lee13.1%9.0%9.2%8.5%

Source: S&P Capital IQ. TTM=trailing 12 months. *Because Sara Lee did not report an effective tax rate three years ago, we used its 39% effective tax rate from one year ago.

H.J. Heinz has the highest returns on invested capital of the listed companies. While its current returns are the lowest they have been in the past three years, they are 2.4 percentage points higher than five years ago. Sara Lee's (NYS: SLE) ROIC is less than 1 percentage point lower than Heinz's, and its current returns are more than 3 percentage points higher than they have been over the past five years. J&J Snack Foods' (NAS: JJSF) ROIC is just under 13%, but those returns have fluctuated over the five-year period, and are currently 1.5 percentage points lower than they were five years ago. ConAgra Foods' (NYS: CAG) ROIC is just below 10%, and its returns have steadily increased over the past three years.

As a major player in the food industry, Heinz offers much of what defensive investors are looking for. Like Yum! Brands and McDonald's (NYS: MCD) , Heinz has expanded into international markets, with a major presence in China, India, and Indonesia. However, like other food businesses, Heinz has suffered from rising food prices, with tomato prices three times higher than they were in 2010, and has responded by reducing its Heinz 57 bottles by 11% to offset the cost. Also, the company substantially increased its dividend last year and has plenty of room to continue increasing it.

Of the four companies in the table, Heinz offers the highest dividend yield, at 3.7%. ConAgra Foods' yield is not far behind, at 3.6%. Sara Lee has a much lower 2.3% yield, and J&J Snack Foods' yield is still lower at 1%.

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., owns shares of McDonald's. The Motley Fool owns shares of Yum! Brands. Motley Fool newsletter services have recommended buying shares of Yum! Brands, McDonald's, and H.J. Heinz. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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