Does ExxonMobil 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 ExxonMobil (NYS: XOM) 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
Source: S&P Capital IQ. TTM = trailing 12 months. *Because ConocoPhillips did not report an effective tax rate, we used its 42% rate from one year ago. **Because BP did not report an effective tax rate, we used its 37% rate from three years ago.
Chevron (NYS: CVX) has the highest returns on invested capital of the listed companies, at nearly 14%. However, its current ROIC is down from five years ago. ExxonMobil's returns aren't far behind Chevron's, but its ROIC is half of what it was five years ago. ConocoPhilips (NYS: COP) and BP (NYS: BP) have comparable current returns, but ConocoPhllips' returns have increased from five years ago, albeit slightly, while BP's have declined.
ExxonMobil has benefited from high oil prices, with a big increase in its revenue from last year. However, with operations all over the world, Exxon faces challenges related to political unrest in the Middle East and elsewhere. In fact, the company is still trying to recover the money it lost when Venezuela nationalized its holdings. The nature of the commodity business in oil also makes it difficult for the company to find ways to boost its margins since profitability is determined significantly by the volatility in oil.
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. Motley Fool newsletter services have recommended buying shares of Chevron and ExxonMobil. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
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