Does Coca-Cola 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 Coca-Cola (NYS: KO) 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 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 Coke and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Coca-Cola14.5%14.7%23.7%23.1%
Monster Beverage (NAS: MNST) 87.7%59.7%35.1%115%
PepsiCo (NYS: PEP) 13.4%14.4%21.7%25.6%
Cott (NYS: COT) 7.3%*7.4%1.4%*5.1%*

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

Monster Beverage has returns on invested capital that dwarf the other companies' ROIC. Sustaining that level of return is quite a feat, suggesting that the company is maintaining its competitive advantage. Coca-Cola has the next highest returns, but its ROIC has consistently declined over the past three years and is significantly lower than it was five years ago, as the company took on some of its bottling operations. PepsiCo's ROIC is not far behind Coke's, but it has also seen consistent declines in its ROIC over the past five years, as it, too, took on some bottling operations. Cott's returns are the lowest of these companies, but it is the only one whose current ROIC is higher than it was five years ago.

Coke offers many features that are attractive to conservative investors. It has cultivated a brand that most Americans recognize and that has become a major part of American culture. Although it's no longer a high-growth company, it's still finding some growth by increasing its product offerings and extending its distribution into emerging markets. While there have been some worries that high sugar prices would eat into these companies' profit margins, the prices of sugar have started to decline again. This stability and attractive ROIC have made Coke one of Buffett's long-term holdings.

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 Coca-Cola and PepsiCo.Motley Fool newsletter serviceshave recommended buying shares of Monster Beverage, Coca-Cola, and PepsiCo and creating a diagonal call position in PepsiCo. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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