Does Exelon 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 look at Exelon (NYS: EXC) 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
(Read more 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 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 of its industry peers over a few periods.
1 Year Ago
3 Years Ago
5 Years Ago
|Duke Energy (NYS: DUK)||3.9%||3.4%||3.5%||1.3%|
|American Electric Power (NYS: AEP)||3.9%||4.2%||4.2%||4.3%|
|National Grid (NYS: NGG)||8.5%||6.4%||5.8%||7.8%|
Source: S&P Capital IQ.
TTM=trailing 12 months.
National Grid has the highest returns on invested capital of these companies, and after a decline in its returns three years ago, they have steadily increased. Exelon has the next highest returns, but its ROIC has declined steadily over the past three years and are lower than they were a half-decade ago. American Electric Power's returns on invested capital are around 4% and have remained fairly close to that level over the past five years. Duke Energy has the lowest returns of these companies, but it has also seen the most substantial gains in its ROIC from five years ago.
Exelon's share prices have remained relatively stable during the economic crisis, and the company has become one of the nation's leading utility providers. Its focus on alternatives to fossil fuels in electricity generation has put the company in a strong position as the government looks for more environmentally friendly energy alternatives.
However, the Japanese earthquake has raised some concerns over nuclear energy as a viable power alternative. These fears have affected other companies with a stake in nuclear power. For example, NRG (NYS: NRG) has written off its investment in its South Texas Nuclear development project, costing it nearly $500 million. Cameco and Uranium Energy, which mine uranium, have also seen their share prices fall. However, despite concerns about nuclear energy, it is still responsible for generating 20% of power in the United States.
These utilities are well loved for their dividends, and you can see why. National Grid has the highest dividend yield at 5.6%. Exelon and American Electric Power are not far behind, at 5.4% and 5%, respectively. Duke's yield comes to 4.8%.
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. Add these companies to your Watchlist:
- Add Uranium Energy to My Watchlist.
- Add NRG Energy to My Watchlist.
- Add National Grid to My Watchlist.
- Add Exelon to My Watchlist.
- Add Duke Energy to My Watchlist.
- Add Cameco to My Watchlist.
- Add American Electric Power to My Watchlist.
At the time this article was published Jim Royal, Ph.D., owns shares of Exelon, National Grid, and Duke. Motley Fool newsletter services have recommended buying shares of National Grid and Exelon and creating a write covered strangle position in Exelon. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't 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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