The problem with looking at high rates of return on shareholders' equity is that some businesses have purposely shrunk their equity base with large dividend payments or share repurchase programs. They do this because increasing the return on shareholders' equity makes the company's stock more enticing to investors. Thus, you will find companies in a price-competitive business, like General Motors, reporting high rates of return on shareholders' equity. To solve this problem, Warren Buffett looks at the return on total capital (ROTC) to help him screen out these types of companies.
ROTC
ROTC is defined as the net earnings of the business divided by the total capital in the business. (Total capital = Equity + Long-Term Debts + Short-Term Debts).
Warren Buffett is looking for a consistently high rate of ROTC, AND, a consistently high rate of ROE.
General Motors' return on equity for the 10-year period (1992 to 2001) was an average annual rate of 27.2%, which is very respectable but suspect because of the 0% return in 1992. Its total return on capital (ROTC) for the 10-year period shows a different story. Its 9.5% average is not enticing. Compare this to H&R Block, which logged in an average annual rate of ROE of 21.5% and an average annual total return on capital (ROTC) of 20.7%.
Take Home Message
- Companies with a durable competitive advantage will consistently earn both a high rate of ROE and a high rate of return on toal capital (ROTC). Again, the key word is CONSISTENT.
- Companies in a price-competitive business, will typically earn a low rate of ROTC.
- Warren Buffett looks for a consistent ROTC of 12% or better.
Also Read:
Return on Total Capital (ROTC)
The Right Rate of Return on Total Capital (ROTC)
ROA of Banks, Investment Banks and Financial Companies
Using ROTC Where the Entire Net Worth of the Company has been taken out
ROTC, ROA, ROE and Buffett's Durable Competitive Advantage
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