Does Frontline Pass Buffett's Test?
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.
ROIC is perhaps the most important metric in value investing. 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.
Let's take a look at Frontline (NYS: FRO) and three of its industry peers, to see how efficiently they use cash. Here are the ROIC figures for each company over a few periods.
1 Year Ago
3 Years Ago
5 Years Ago
|Nordic American Tankers (NYS: NAT)||(4.3%)||0.9%||13.4%||15.2%|
|Ship Finance International (NYS: SFL)||5.2%||5.7%||7%||13.2%|
|DryShips (NAS: DRYS)||2.5%||5.4%||15.2%||7.2%|
Source: S&P Capital IQ. TTM = trailing 12 months. *Because Frontline did not report an effective tax rate, we used its 0.2% effective tax rate from one year ago.
Frontline has seen dramatic decreases in its returns on invested capital over the past five years, as have the other listed companies. And that squares well with the total breakdown seen in much of the shipping industry, as supply vastly outstripped demand, leading to the declines at each of these four players.
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:
- Add Ship Finance International to My Watchlist.
- Add Nordic American Tankers to My Watchlist.
- Add Frontline to My Watchlist.
- Add DryShips to My Watchlist.
At the time this article was published
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