Does United Parcel Service 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, in order 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 take a look at several companies in a single industry to determine their ROIC. Let's take a look at United Parcel Service (NYS: UPS) 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

The nuances of the formula are explained in further detail here. 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 four industry peers over a few periods:

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

United Parcel Service16.6%14.7%14.1%17.0%
FedEx9.3%7.4%6.0%11.0%
Expeditors International of Washington48.2%45.6%41.7%37.1%
YRC Worldwide(5.4%)*(8.1%)*(1.4%)*7.4%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because YRC Worldwide did not report an effective tax rate, we used its 39% rate from 5 years ago.

Expeditors International of Washington (NAS: EXPD) has by far the highest returns on invested capital of the listed companies, and has shown consistent growth in its ROIC over the five-year period, suggesting its competitive position is growing stronger. UPS has the next highest returns, but its ROIC is down from five years ago. FedEx (NYS: FDX) has ROIC several percentage points behind UPS', and it has also seen declines in its ROIC from five years ago. YRC Worldwide (NAS: YRCW) has returns on invested capital in the negative numbers, and its current ROIC is much lower than it was five years ago.

With prices frequently more reasonable than competitors like FedEx, UPS is well-positioned to benefit from the U.S. Postal Service's move to raise prices and pull back service. UPS has also benefited from its relationship with Amazon.com. While the high cost of fuel has the potential to eat into UPS' profit margins due to the expense of powering its delivery fleet, the company has a deal with Union Pacific (NYS: UNP) to use its railroads in freight delivery.

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. If you'd like to add these companies to your Watchlist, click below:

At the time this article was published Jim Royal, Ph.D., does not own shares of any company mentioned here. The Motley Fool owns shares of Amazon.com and Expeditors International of Washington. The Fool has created a butterfly spread position in Expeditors International of Washington.Motley Fool newsletter serviceshave recommended buying shares of Amazon.com and FedEx. The Motley Fool has adisclosure policy. We Fools may not 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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