Does AgFeed Industries 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 AgFeed Industries (NAS: FEED) 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 on the nuances of 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 AgFeed and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

AgFeed Industries(8.7%)*3.8%20%60.2%
Zhongpin (NAS: HOGS) 11.9%10.3%15%9.8%
Pilgrim's (NYS: PPC) (10.5%)**6.8%**(15%)**0.4%**
Hormel Foods (NYS: HRL) 15.4%15.9%11.4%12.8%

Source: S&P Capital IQ.
TTM=trailing 12 months.
*Because AgFeed Industries did not report an effective tax rate, we used its 25% rate from one year ago.
**Because Pilgrim's did not report an effective tax rate, we used a 35% rate.

Hormel Foods has the highest returns on invested capital of these companies, and after a drop in its returns three years ago, it has consistently increased its ROIC over the past three years. Zhongpin has the next highest ROIC, and while its returns are higher than they were five years ago, they have fluctuated a great deal in the interim. AgFeed has ROIC in the low negative numbers, which are caused by negative EBIT, and those returns have consistently and dramatically declined over the past five years. Pilgrim's has even lower ROIC, with its negative returns at TTM and three years ago having been caused by negative EBIT. Pilgrim's returns have fluctuated a great deal over the five-year period.

Many companies in the agriculture business have been able to benefit from higher crop prices. However, as an animal nutrition and production business, these higher crop prices mean the cost of doing business has gone up for AgFeed. While the emerging middle class in China holds some hope for growth for AgFeed as the demand for meat goes up, current market conditions have not been favorable for the company.

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 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 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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