Does Hewlett-Packard 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 Hewlett-Packard (NYS: HPQ) 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 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 HP and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Hewlett-Packard10.4%15.2%14.3%15.6%
Computer Sciences (NYS: CSC) (9.6%)*9.3%11.8%10.1%*
Unisys (NYS: UIS) 28.4%32.3%4.1%**0.3%**
IBM (NYS: IBM) 23.3%22.1%19.3%14.8%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because Computer Sciences did not report an effective tax rate, we used its 15.3% rate from one year ago.
**Because Unisys did not report an effective tax rate, we used its 31.4% effective tax rate from TTM.

Unisys has by far the highest returns on invested capital of these companies. While its returns have declined from last year, they have grown significantly from five years ago. IBM also has returns in the 20% range, and the company has seen its returns increase substantially and consistently over the five-year period. Hewlett-Packard's returns are currently above 10%, but they are the lowest they've been in five years, suggesting that its competitive position is eroding. Computer Sciences has seen drastic reductions in its ROIC over the past three years, with current returns in the low negative numbers.

Hewlett-Packard has had no shortage of setbacks recently. The company's launch of its TouchPad tablet has produced disappointing sales, which it had to respond to by temporarily discounting its price to $99 so it could turn over inventory. The company's former CEO Leo Apotheker also made a number of bad decisions that hurt the company, including an attempt to spin off its PC business and its expensive purchase of British software company Autonomy.

While the company's recent appointment of Meg Whitman to CEO brings hope for future improvement, it still faces a number of challenges, including pressure from competitors such as Dell in the commodity-like aspects of its hardware business. Hewlett-Packard also has to find ways to compete with software companies such as Oracle and IBM, which have a head start on HP in the growth of their software businesses.

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. You can also 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 Oracle.Motley Fool newsletter serviceshave recommended writing covered calls on Dell. 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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