The Right Rate of Return on Total Capital (ROTC)
Problem with ROE
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 total 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.
=====
Here is a detailed expansion and discussion of the provided text, followed by a concise summary.
Expansion and Discussion
The core message is that while Return on Equity (ROE) is a popular metric for judging a company's profitability, it can be manipulated and is often insufficient on its own. The solution is to use it in conjunction with Return on Total Capital (ROTC), which provides a more holistic view of a company's true operational efficiency.
1. The Problem with ROE: A Flawed King
Return on Equity (ROE) measures how effectively a company generates profits from every unit of shareholders' equity. It's calculated as:
ROE = Net Income / Shareholders' Equity
The Problem: A high ROE can be a mirage. Companies can artificially inflate their ROE not by increasing earnings, but by reducing the denominator—Shareholders' Equity. This is done through two primary methods:
Large Dividend Payments: This directly transfers equity from the company to shareholders.
Share Buybacks: When a company repurchases its own shares, the money used is deducted from shareholders' equity, shrinking the equity base.
Why do they do this? A higher ROE makes the company appear more efficient and profitable to investors who rely on this single metric, potentially driving up the stock price. The example of General Motors is perfect. As a capital-intensive, price-competitive business in the auto industry, its underlying profits are not exceptionally high. By shrinking its equity base, it could report a seemingly "very respectable" average ROE of 27.2% over a decade, masking its true competitive weakness.
2. The Solution: ROTC - The True Measure of Efficiency
Return on Total Capital (ROTC) broadens the perspective by considering all the permanent capital used to run the business, not just equity. It is calculated as:
ROTC = Net Earnings / Total Capital
Where Total Capital = Shareholders' Equity + Long-Term Debt + Short-Term Debt
ROTC answers the question: "Regardless of how this business is financed (with equity or debt), how good is it at generating returns on the entire pool of capital employed?"
This metric is much harder to manipulate with financial engineering. A company cannot easily hide its need for debt and equity to fund its operations. When we apply ROTC to General Motors, the story changes dramatically. Its impressive 27.2% ROE collapses into a mediocre 9.5% ROTC. This reveals that GM is not a particularly efficient generator of profits relative to the massive amount of capital (factories, equipment, inventory) it requires to operate.
In contrast, H&R Block shows consistency. Its ROE (21.5%) and ROTC (20.7%) are both high and very close to each other. This indicates that the company is genuinely profitable from its operations and is not relying on debt or equity shrinkage to appear successful. This is a classic sign of a company with a durable competitive advantage (in H&R Block's case, a strong brand and a recurring, essential service).
3. The Take-Home Message: The Buffett Filter
Warren Buffett's strategy, as described, uses the combination of ROE and ROTC as a powerful filter to identify exceptional businesses.
The Durable Competitive Advantage: Companies with a wide "economic moat" (a strong brand, pricing power, proprietary technology) can consistently earn high returns on both equity and total capital. They don't need to compete solely on price, which erodes margins. Their high ROTC proves their operational excellence, and their high ROE confirms that this excellence translates into strong returns for shareholders. Consistency is key—it shows the advantage is structural, not a one-time event.
The Price-Competitive Business: Companies in industries like automotive, airlines, or commodity manufacturing typically earn a low ROTC. They are forced to compete on price, and the immense capital required for their operations (factories, fleets of planes) generates relatively low returns. Their profits are cyclical and thin.
The Benchmark: Buffett looks for a consistent ROTC of 12% or better. This hurdle rate signifies a business that generates more than enough profit to cover its cost of capital and create genuine value for its owners over the long term.
Summary
In essence, the passage warns against relying solely on Return on Equity (ROE), as it can be artificially inflated by share buybacks or dividends, making a company look more efficient than it is. The solution is to also analyze Return on Total Capital (ROTC), which measures profitability against all capital invested (equity + debt), providing a clearer picture of true operational efficiency.
Key Conclusions:
A high ROE can be deceptive. Always check if it's driven by a shrinking equity base rather than growing earnings.
ROTC is the reality check. A genuinely great business will show both a high ROE and a high ROTC.
Consistency is the hallmark of quality. Companies with a durable competitive advantage, like H&R Block in the example, will post consistently high numbers for both metrics.
Use them together. By demanding both a consistently high ROE and a consistently high ROTC (Buffett's benchmark is 12%+), an investor can screen out financially engineered mirages and identify truly exceptional, profit-generating machines.
No comments:
Post a Comment