Does International Paper 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.

In this series, we take a look at several companies in a single industry to determine their ROIC. Let's take a look at International Paper (NYS: IP) 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:

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.

Source: S&P Capital IQ. TTM=trailing 12 months.
* Because PKG did not report an effective tax rate, we used its 37% rate from three years ago.
** Because IP did not report an effective tax rate, we used its 35% rate from five years ago.
*** Because UFS did not report an effective tax rate, we used its 32% rate from three years ago.

International Paper has current returns on invested capital comparable to its industry peers, but it shows the kind of steady growth over the past five years that we like to see. Packaging Corporation of America and Domtar also have returns in the 10% range, but while their returns are up from five years ago, they have fluctuated in the interim. Rock-Tenn's ROIC is much lower than its industry peers, at 3.7%, and its returns are down by 1.5 percentage points from five years ago.

International Paper is also appealing since its dividend yield has nearly doubled from last year, with a current yield of 3.7%, and it has also grown its revenues and margins over the same time period. International Paper has also improved its competitive position by moving to buy out Temple-Inland (NYS: TIN) , which it expects to create synergies of $300 million per year. Rock-Tenn has also moved to enlarge its business by purchasing Smurfit-Stone.

While the merger will create certain advantages for International Paper, it may face additional challenges in the future due to an increase in timber prices. Furthermore, now that it has sold off much of its timber-producing land, it will not be able to mitigate the effects of this price increase with its production of this raw material. So high prices could hit margins.

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 Domtar to My Watchlist.

• Add Temple-Inland to My Watchlist.

• Add Rock-Tenn to My Watchlist.

• Add Packaging Corporation of America to My Watchlist.

• Add International Paper to My Watchlist.

• Add Resolute Forest Products to My Watchlist.

At the time thisarticle was published Jim Royal, Ph.D., does not own shares of any company mentioned here.The Motley Fool owns shares of Rock-Tenn. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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