Does DuPont 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 DuPont (NYS: DD) 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 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 DuPont and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

DuPont11.9%12.4%11.4%13.8%
Ashland (NYS: ASH) 1.5%*2.9%0.5%4.7%
Dow Chemical (NYS: DOW) 6%5.3%3.5%10.9%
Albemarle (NYS: ALB) 19.6%15.2%10.1%**13.5%

Source: S&P Capital IQ. TTM=trailing 12 months.
*Because Ashland did not report an effective tax rate, we used a 35% tax rate.
**Because Albemarle did not report an effective tax rate, we used its 21.5% rate from one year ago.

Albemarle's returns on invested capital are far higher than the other companies, and it has shown consistent growth in its returns over the past three years. DuPont is the only other company with returns above 10%, but its ROIC is down from five years ago. Dow Chemical also currently has lower returns than it did five years ago, but it has seen consistent growth in its ROIC over the past three years. Ashland has the lowest returns of the companies, and its current ROIC is less than one-third of what it was five years ago.

DuPont has benefited from good economic times for the chemical industry, which has seen high demands for its products despite a struggling global economy. It also offers a high dividend yield at 3.1%, which beats out Ashland's 1.1% yield, Dow's 2.9%, and Albemarle's 1.3%. Industry peer Olin (NYS: OLN) also stands out in this area with 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 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.

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