Does Reynolds American 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 Reynolds American (NYS: RAI) 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.



1 Year Ago

3 Years Ago

5 Years Ago

Reynolds American










Altria Group





Philip Morris International





Source: S&P Capital IQ. TTM = trailing 12 months.

Philip Morris (NYS: PM) offers returns on invested capital above 40%, which beats the ROIC of its competitors. Over the five-year period, it has seen fairly steady returns in the 34% range until its returns jumped in the past year. Reynolds American and Altria Group (NYS: MO) both offer current returns close to 15%. While Reynolds' returns have increased solidly from five years ago, Altria has more than tripled its ROIC over the same time period. Lorillard (NYS: LO) , on the other hand, has been consistently producing returns in the low negative numbers over the past three years. Don't fear: That's a result of negative invested capital rather than poor earnings, and it's a great position for a business to be in.

Like other tobacco companies, Reynolds American has faced pressures from increases in regulation. While tobacco companies have managed to maintain big profits, investors are often scared away by fear of law suits and other attacks to the industry. Reynolds and peers like Lorillard and Vector Group (NYS: VGR) have responded to government pressures by filing a suit to prevent more requirements to add further graphic warnings on their cigarette packaging. They achieved some success on this front in November, when the court ruled that these restrictions violated Reynolds' rights to freedom of speech and prevented the additional labeling requirements from taking effect until it comes to a decision on the lawsuit. While some investors are looking to Philip Morris and British American Tobacco to avoid the risks of U.S. litigation and regulation costs, other countries are now starting to increase their regulations on tobacco as well.

While Philip Morris' returns are by far the highest of the listed companies, it offers the lowest dividend yield, at 3.8%. Lorillard, on the other hand, offers a 4.2% dividend yield, and Reynolds and Altria both offer a 5.6% 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. If you'd like to add these companies to your Watchlist, click below:

At the time thisarticle was published Jim Royal, Ph.D., owns shares of Philip Morris.The Motley Fool owns shares of Altria Group and Philip Morris International.Motley Fool newsletter serviceshave recommended buying shares of Philip Morris International. 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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