Does Amazon.com 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 Amazon.com (NAS: AMZN) 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 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 Amazon and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Amazon.com 49.1% (319.6%) (570.5%) (114%)
Overstock.com (NAS: OSTK) NM (25.3%) NM (341.5%)
eBay (NAS: EBAY) 12.9% 16% 18.2% 13.3%
Blue Nile (NAS: NILE) (21.6%) (22.1%) (30.7%) (21.5%)

Source: S&P Capital IQ. TTM=trailing 12 months. NM = not measurable.

Amazon.com has by far the highest returns on invested capital of these companies. And don't worry about those negatives in prior years: That's due simply to Amazon's negative invested capital, a great position for the company to be in. That's the same situation at Overstock.com over the past three periods, but in Overstock's case, it was unable to turn an operating profit in the TTM and three-year period.  eBay's returns have fluctuated some in the past few years and are down substantially from three years ago. Blue Nile has current returns in the low negative numbers, but again that's because the company has negative invested capital in its business.

Amazon.com has managed to bring in sales far higher than any other major Internet retail company. In addition, it has entered into new markets by competing with salesforce.com and Rackspace Hosting in cloud computing. It has also extended into the mobile-device market by introducing its Kindle Fire product to compete with Apple's iPad. Finally, Amazon has started to compete with Netflix in offering streaming video content. While some of these moves have hurt Amazon's returns in the short term, they may offer long-term growth potential if Amazon can get customers used to its products in these areas.

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:

At the time this article was published Jim Royal, Ph.D., owns no shares of any company mentioned here. The Motley Fool owns shares of Apple and Amazon.com. Motley Fool newsletter services have recommended buying shares of Rackspace Hosting, Netflix, salesforce.com, Apple, eBay, Amazon.com, and Blue Nile. Motley Fool newsletter services have recommended creating a call spread risk reversal position in Blue Nile, writing puts on eBay, creating a bull call spread position in Apple, and creating a bear put spread position in salesforce.com. The Motley Fool has a disclosure policy. We Fools don't 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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