Does Novartis 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 Novartis (NYS: NVS) 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.

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% 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.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Novartis

11.4%

11%

13.2%

13%

Pfizer

9.9%

11%

19.3%

18.9%

GlaxoSmithKline

26.2%

23.2%

25.1%

35.3%

Merck

12.1%

6.8%

17.2%

17.4%

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

GlaxoSmithKline (NYS: GSK) has the highest returns on invested capital of the listed companies -- more than twice as high as those offered by runner-up Merck (NYS: MRK) . However, GlaxoSmithKline's return is significantly lower than it was five years ago. That isn't uncommon, as Novartis, Pfizer (NYS: PFE) , and Merck have all have ROIC that has seen major declines over the past five years.

Novartis is a pharmaceutical company that both develops new drugs and produces generic drugs. The company's Onbrez Breezhaler treatment, which was developed for patients who have obstructive pulmonary disease, gained approval in Europe in mid-2010 and FDA approval in March 2011. Novartis' involvement in generic drugs through its Sandoz unit has the downside of lowering the company's margins but the upside of reducing risk associated with major decreases in sales following the expiration of its patents.

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, 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., does not own shares of any company mentioned here.Motley Fool newsletter serviceshave recommended buying shares of GlaxoSmithKline, Novartis, and Pfizer. 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.