ROTC, ROA, ROE and Buffett's Durable Competitive Advantage

ROTC, ROA, ROE and Buffett's Durable Competitive Advantage

https://myinvestingnotes.blogspot.com/2009/06/relating-rotc-and-roa-to-durable.html

1. Warren Buffett has learned that a consistently high return on total capital is indicative of a durable competitive advantage. He is looking for a consistent ROTC of 12% or better.

2. With banks and finance companies he looks at the return of total assets ROA to determine if the company is benefitting from some kind of durable competitive advantage. Warren Buffett looks for a consistent return on assets ROA in excess of 1% (anything over 1% is good, anything over 1.5% is fantastic) and a consistent ROE in excess of 12%.

3. In situations where the entire net worth of the company is paid out, creating a negative net worth, Warren Buffett has only made investments in those companies that show a consistent ROTC of 20% or more. The high ROTC is indicative of a durable competitive advantage.

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Here is a detailed elaboration, discussion, and summary of Warren Buffett's use of ROA, ROE, and ROTC as indicators of a durable competitive advantage (often called an "economic moat").

Elaboration: The Three Metrics and Their Buffett Context

1. ROTC (Return on Total Capital)

• What it is: Measures how efficiently a company uses all its permanent capital (both equity and long-term debt) to generate profits. Formula: Earnings Before Interest & Taxes (EBIT) / (Shareholders' Equity + Long-Term Debt).

• Buffett's Threshold: A consistent 12% or better. He looks for consistency over time, not just a single high year. This indicates the company can deploy large amounts of capital at high rates of return—a key sign of a moat.

• Key Insight: Because it uses pre-interest earnings (EBIT) and includes debt, ROTC neutralizes the effects of different capital structures (how much debt vs. equity a company uses). It focuses purely on the operating efficiency of the core business.

2. ROA (Return on Assets) & ROE (Return on Equity) for Financials

• Why separate for banks/financials? For these companies, debt is the raw material of the business (e.g., deposits for banks, premiums for insurers). Their assets are predominantly financial (loans, securities). Therefore, standard ROTC is less meaningful.

• ROA (Return on Assets): Net Income / Total Assets. Buffett looks for consistently over 1% (excellent if over 1.5%). A consistently high ROA for a bank indicates it is skilled at underwriting (lending) and investing without taking excessive risk. It suggests pricing power, operational efficiency, and a valuable, low-cost deposit base—all forms of a competitive advantage.

• ROE (Return on Equity): Net Income / Shareholders' Equity. Even for financials, Buffett seeks consistently over 12%. This ensures the company is not just efficient with assets but also generates a superb return for its owners.

3. The "Negative Equity" Exception & High ROTC Bar

• The Scenario: Some exceptional companies generate so much cash that they can pay out all their cumulative earnings as dividends or share buybacks, effectively reducing their retained earnings (and thus shareholder equity) to zero or negative. Think of powerful brands like Moody's or See's Candies.

• Buffett's Adjusted Metric: In these cases, ROE becomes distorted or infinite. Therefore, he reverts to ROTC, but raises the bar significantly to 20% or more. This extreme profitability with minimal capital reinvestment is the ultimate sign of a durable competitive advantage—a "toll-bridge" or "franchise" business that prints money.

Discussion: The Underlying Philosophy and Connections

1. Consistency is the True Signal: Buffett is not looking for a single year's spike. He looks for a decade or more of consistently high metrics. This consistency proves the advantage is durable and can withstand economic cycles, competition, and management changes. Volatility in these returns suggests a cyclical commodity business, not a moat.

2. The Hierarchy of Metrics Reflects Business Model:

• For most businesses (Coca-Cola, Apple): ROTC is the primary gauge because it isolates business quality from financing decisions.

• For financial businesses (Bank of America, American Express): ROA is the key operational metric, supplemented by ROE.

• For capital-light franchise businesses: An extremely high ROTC (20%+) is the tell-tale sign, even trumping ROE.

3. The "Why" Behind the Numbers: These metrics are the output, not the cause. A high and consistent ROTC/ROA/ROE is the result of the durable competitive advantage, which can stem from:

• Brand Power (Coca-Cola): Allows pricing power.

• Cost Advantages (GEICO): Creates a low-cost structure.

• Network Effects (American Express): Makes the service more valuable as more use it.

• High Switching Costs (See's Candies, Moody's): Locks in customers.

4. The Avoidance of "Look-Through" Debt: By focusing on ROTC (using EBIT) for industrials, Buffett avoids being fooled by a high ROE achieved through excessive leverage (debt). A highly leveraged company can have a high ROE but be very risky. Buffett prefers profits from business strength, not financial engineering.

Summary: The Buffett Framework for Identifying a Moat

In essence, Warren Buffett uses these profitability ratios as a forensic tool to identify a business's underlying economic reality. He seeks consistent excellence in these metrics as evidence that a company possesses a durable competitive advantage (moat). The specific metric he emphasizes depends on the business model, but the ultimate goal is the same: to find a business so fundamentally strong that it can generate high returns on capital for many years into the future, with minimal need for additional investment. This is the engine behind Berkshire Hathaway's compounding value.