Does Peabody Energy 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 Peabody Energy (NYS: BTU) 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

Peabody Energy8.4%10.9%15%4.6%*
Arch Coal4.6%**5.9%11.9%8.7%**
CONSOL Energy7.9%4.8%6.9%7.5%
Patriot Coal(1.6%)***(0.5%)***4.6%2.5%

Source: S&P Capital IQ. TTM=trailing 12 months. *Because Peabody Energy did not report an effective tax rate, we used its 27.6% rate from 1 year ago. **Because Arch Coal did not report an effective tax rate, we used its 10.5% rate from 3 years ago. ***Because Patriot Coal did not report an effective tax rate, we used a 35% rate.

Peabody Energy's returns on invested capital are the highest of the listed companies, but its returns have declined over the past five years. However, they are significantly higher than they were five years ago. CONSOL Energy (NYS: CNX) has the second highest ROIC, but those returns gradually declined until last year, when they increased again by more than 3 percentage points. Arch Coal (NYS: ACI) and Patriot Coal (NYS: PCX) have seen steady declines in their ROIC over the past three years, with Patriot Coal throwing out negative numbers over the last two periods.

Coal business Peabody Energy has attempted to improve its competitive position by expanding into global markets. In 2010, CEO Gregory Boyce said, "Peabody believes that the global coal industry is in the early stages of a long term supercycle, led by China and India. Peabody's access to these key markets represents significant value creation opportunity."

In order to cultivate this opportunity, Peabody has partnered with BHP Billiton (NYS: BHP) to expand a key port in Australia and facilitate an agreement with Diana Shipping to devote specially built ships to the transport of their coal. Peabody also beat out steelmakers POSCO, ArcelorMittal, and Vale in July by scoring a role as part of a consortium to build a mine in Mongolia.

Peabody and CONSOL Energy offer modest dividend yields in the 1% range, while Arch Coal offers a much higher yield at 3.1% and Patriot Coal fails to offer a dividend at all.

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., does not own shares of any company mentioned here. The Motley Fool owns shares of Arcelor Mittal. 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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