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, 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 examine several companies in a single industry to determine their ROIC. Let's take a look at Exelon 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
(Get further detail on the nuances of the formula.)
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 it 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 Exelon and three industry peers over a few periods.
1 Year Ago
3 Years Ago
5 Years Ago
Source: S&P Capital IQ. TTM=trailing 12 months.
Dominion Resources has the highest returns on invested capital at 5%, and it has maintained returns close to those rates over the past five years. Exelon and Duke Energy both offer 3% or so returns on invested capital. While Duke has managed to keep its returns close to the 3% range over the past five years, Exelon's returns have steadily declined over the five-year period. Southern has performed a bit better, but it too has seen ROIC decline over the past five years.
Exelon has exposure to a wide range of energy sources, including nuclear, renewable, and fossil-fuel energy. This helps shelter the company from declines in demand for a particular energy source. For example, new regulations requiring coal-fired plants to convert to gas-fired plants initially looked like they would deal a much larger blow to companies like Southern and Duke, which relied heavily on fossil fuels, than it did to the more diversified Exelon.
However, significant declines in natural gas prices later allowed these rivals to lower production costs to make up for the expenses associated with these conversions, which undermined Exelon's competitive advantage. Increased demand related to lower natural gas prices has also helped Dominion as it delivers natural gas to individual consumers through its utility business and transports and stores natural gas through its pipelines and storage systems.
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.
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The article Does Exelon Pass Buffett's Test? originally appeared on Fool.com.
Jim Royal owns shares of Southern and Exelon. The Motley Fool recommends Dominion Resources, Exelon, and Southern. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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