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.

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

Nordic American Tankers(4.9%)0.3%15.6%9.3%
Ship Finance International5.3%5.6%6.5%8.4%

Source: S&P Capital IQ. TTM = trailing 12 months.
*Because Frontline did not report an effective tax rate for TTM, we used its 0.1% effective tax rate from one year ago.
**Because DryShips did not report an effective tax rate for TTM, we used a 0% effective tax rate.

Ship Finance International (NYS: SFL) has the highest returns on invested capital of the listed companies, at above 5%. However, those returns have declined consistently over the past five years. DryShips (NAS: DRYS) has current returns at 3.7%, but those have also declined consistently over the past three years, and are the lowest they have been in the period listed above. Frontline's returns have also declined consistently and dramatically over the past three years, and are much lower than they were five years ago. Nordic American Tankers (NYS: NAT) has an ROIC at almost -5%, and it has also seen massive declines over the past three years.

Shrinking demand, an oversupply of cargo shippers, and an inability to gain access to credit has created a difficult economic environment for companies in dry bulk shipping, including Frontline. Because Frontline operates oil tankers, it is also suffering from a reduction in oil production due to civil conflict in Northern Africa and the Middle East, while increased oil exploration and new oil discoveries in the U.S. have led to a reduced demand to ship oil from other places. These challenges in oil shipping affect not only Frontline, but also Ship Finance International and Nordic American Tankers.

While many shipping companies are suffering, some have done better than others. Teekay (NYS: TNK) has a large dividend (currently at a 10% yield) that it could decrease, if necessary, to conserve cash in the short term. This could help create enough of a safety net to help Teekay weather the storm of the challenges faced by shipping tankers, which could allow it to emerge with a competitive advantage over companies who couldn't make it. DryShips has also been able to get a leg up over other companies in the industry by locking in contracts that take up 54% of its dry bulk capacity at an average rate of about $35,000 per day for 2012 .

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.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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