Does General Dynamics 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 General Dynamics (NYS: GD) 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 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 about 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 General Dynamics and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

General Dynamics12.8%14%14.5%13.8%
Textron   (NYS: TXT) 3.8%2.6%*5%6.4%
Harris (NYS: HRS) 13.6%18%18.2%19.2%
Northrop Grumman (NYS: NOC) 13.8%12.4%8.9%**7%

Source: S&P Capital IQ. TTM=trailing 12 months.
Because Textron did not report an effective tax rate, we used its 28% rate from TTM.
**Because Northrop Grumman did not report an effective tax rate, we used its 31% rate from five years ago.

General Dynamics, Harris, and Northrop Grumman all have returns on invested capital within 1 percentage point of each other. However, while Northrop Grumman's ROIC has steadily increased over the past five years and is almost double what it was back then, Harris has seen steady declines in its ROIC over the same time period, with current returns more than 5.5 percentage points lower than five years ago. General Dynamics' returns have steadily decreased over the past three years and are also lower than they were five years ago. Textron saw steady declines in its ROIC until last year, after which its returns increased again, but to a level that leaves a lot to be desired.

The defense contracting industry has recently been suffering from threats to cut defense budgets. Before this crisis, General Dynamics, Raytheon, and Lockheed Martin were working on a contract to develop a prototype for a new combat vehicle. However, in September, the government cut the budget for this project, which hurt all of the companies involved. The budget crisis certainly hasn't helped General Dynamics, but the company was suffering from slowing revenue growth even before rumors surfaced of budget cuts in defense.

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 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. The Motley Fool owns shares of Northrop Grumman, General Dynamics, Textron, Lockheed Martin, and Raytheon. 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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