Does PPL 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 PPL (NYS: PPL) 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% 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

PPL5.7%5.3%7.0%7.0%
Calpine4.2%*4.9%*4.8%*2.8%
Dominion Resources5.1%5.8%6.0%5.5%
Progress Energy3.9%4.4%4.4%4.8%

Source: S&P Capital IQ. TTM=trailing 12 months. *Because Calpine did not report an effective tax rate, we used its 24% rate from five years ago.

PPL offers the highest returns on invested capital of the listed companies, but its current ROIC is lower than it was five years ago. Dominion Resources (NYS: D) also offers returns on invested capital in the 5% range, but its ROIC has steadily declined over the past three years. Calpine's (NYS: CPN) ROIC is just above 4%, and has increased by 1.4 percentage points from five years ago. Progress Energy (NYS: PGN) offers returns just below 4%, and they have also gradually declined over the five-year period.

PPL, along with Southern Co., FirstEnergy, and other major players in the utility industry, has performed well in the last year, with substantial increases in its gross margins from last year. PPL has benefited from recent low gas prices, which has allowed it to reduce costs and gain a competitive advantage over largely nuclear power-based companies like Exelon. PPL, like National Grid (NYS: NGG) , also has a nice advantage arising from its involvement in markets outside of the U.S.

PPL, Dominion Resources, and Progress Energy all offer dividends in the 4% range, at 4.9%, 4.2%, and 4.5%, respectively.

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 National Grid, Dominion, Southern, and Exelon. Motley Fool newsletter services have recommended buying shares of National Grid, Dominion Resources, Southern, and Exelon, as well as writing a covered strangle position in Exelon. 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.

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