Does SanDisk 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 SanDisk (NAS: SNDK) 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

(Read more 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 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 SanDisk and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

SanDisk16.4%26.5%(19%)*7.9%
STEC (NAS: STEC) 18.6%17.5%2.2%11%
Seagate Technology (NAS: STX) 26%37%**16.4%**8.1%
Western Digital (NYS: WDC) 36.2%41.1%38.9%55.7%***

Source: S&P Capital IQ.
TTM=trailing 12 months.
*Because SanDisk did not report an effective tax rate, we used its 33% rate from TTM.
**Because Seagate did not report an effective tax rate, we used its 15% rate from five years ago.
***Because Western Digital did not report an effective tax rate, we used its 8% rate from one year ago.

Western Digital has the highest ROIC of these companies, but its returns have declined substantially from five years ago. Seagate Technology has the second highest returns, but its returns declined dramatically this year after huge increases from five years ago up to that point. STEC and SanDisk have returns that are currently fairly comparable, but while STEC's returns have steadily increased over the past three years, SanDisk's returns have fallen by more than 10 percentage points from last year.

SanDisk has benefited a great deal from the extreme popularity of smartphones and tablets, which require flash memory products like the ones produced by SanDisk and competitors such as Micron Technology. However, its continued success relies on its ability to continue to compete effectively in this area.

The increasing popularity of solid-state storage is promising for SanDisk. If this type of storage becomes the industry standard, it will put the company at a huge advantage over companies that focus on optical and magnetic storage, like Western Digital, STEC, and Seagate Technology.

Finally, while Western Digital, SanDisk, and STEC fail to offer a dividend at all, Seagate Technology currently offers a 3.7% yield.

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. 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 Western Digital. 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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