Does Intel 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, 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 Intel 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:

(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 Intel and three industry peers over a few periods.

Source: S&P Capital IQ. TTM = trailing 12 months. *Because Applied Materials did not report an effective tax rate for TTM and three years ago, I used its 30.7% effective tax rate from five years ago. **Because AMD did not report an effective tax rate for any of the listed years, we used a 30% effective tax rate.

Intel and Texas Instruments both have returns on invested capital far higher than the other listed companies. However, Intel has seen its returns decline by almost 8 percentage points from three years ago, and Texas Instruments has seen its returns decline by 10 percentage points over the same period. Applied Materials' returns are much lower, and its returns have fluctuated a great deal over the five-year period, with 25.7% returns five years ago. AMD has returns around negative 20% for the trailing 12 months. And aside from last year, its returns on invested capital have pretty consistently been negative. In each case, negative ROIC has resulted from negative earnings, which is not a good sign.

Qualcomm's domination of the market for the mobile chips and processors has made it difficult for Intel and Texas Instruments to benefit from the popularity of smart phones and other mobile devices. Consequently, Texas Instruments has decided to no longer compete in that space.

Applied Materials has faced its own struggles as the global economic downturn has caused major customers Taiwan Semiconductor and United Microelectronics to reduce their chip orders. Also, the declining market for PCs has dealt Applied Materials a blow similar to that faced by Intel as the demand for its chips also goes down.

As noted above, Advanced Micro Devices has suffered from negative earnings. However, with Sony'sdecision to use AMD's technology in its upcoming PlayStation, the chipmaker could see its revenue grow in the future.

Businesses with consistently high ROICint 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.

When it comes to dominating markets, it doesn't get much better than Intel's position in the PC microprocessor arena. However, that market is maturing, and Intel finds itself in a precarious situation longer term if it doesn't find new avenues for growth. In this premium research report on Intel, a Motley Fool analyst runs through all of the key topics investors should understand about the chip giant. Click here now to learn more.

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Jim Royal has no position in any stocks mentioned. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel and Qualcomm. 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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