Valuing High Growth Companies

The recommended standard valuation principles apply to high-growth companies too.

There is a difference in the order of the steps of the valuation process and the emphasis on each step.

1.  The analyst should forecast the development of the company's markets and then work backward.

2.  The analyst should create scenarios concerning the market's possible paths of development.

3.  When looking into the future, the analyst should also estimate a point in time at which the company's performance is likely to stabilize and then work backward from that point.

4.  By then, the company will have captured a stable market share; and one part of the forecasting process requires determining the size of the market and the company's share.

5.  Then, the firm must estimate the inputs for return:  operating margins, required capital investments, and ROIC.

6.  Finally, the analyst should develop scenarios and apply to the scenarios a set of probability weights consistent with long-term historical evidence on corporate growth.




########################

Time  ------->

Today ..... Rapid Growth ...... Growth Stabilizes .......

Today .....Growing Market Share .....Stable Market Share

Today..... How big is the market? .... How big is the market and the company's share?


Calculating the return:

1.  What is its total revenue?
2   What are its operating margins?
3.  What are its net operating profit after adjusting for tax?
4.  What are its capital investments?
5.  Calculate its ROIC

Alternative Measures of Return on Capital

The primary measure of return on capital is return on invested capital (ROIC).


ROIC = net operating profit less adjusted taxes (NOPLAT) divided by invested capital.

ROIC correctly reflects return on capital in most cases, but special circumstances require alternative measures.



Intangible assets

More specifically, investments in intangible assets are expensed, which can introduce a negative bias in ROIC and lead managers to make incorrect decisions concerning how to create value.




Three issues to focus on handling such complexities

1.   When does ROIC accurately reflect the true economic return on capital?

• When does a more complex measure, such as cash flow return on investment (CFROI) make sense?

2.  How should one deal with investments in R&D and marketing and sales that are expensed when they are incurred?

• Creating pro forma financial statements that capitalize these expenses can provide more insight into the underlying economics of a business.

3.  How should one analyze businesses with very low capital requirements?

• Here it is recommended to use economic profit, or economic profit scaled by revenues, to measure return on capital.

Investments in R&D and other intangibles should be capitalized

Investments in R&D and other intangibles should be capitalized for three reasons:

• to represent historical investment more accurately
• to prevent manipulation of short-term earnings, and 
• to improve performance assessments of long-term investments.

These change only the perceptions of performance, however, and will not change the value of the firm.
Since free cash flow (FCF) includes both operating expenses and investment expenditures, capitalizing an expense will not affect FCF.



The process for capitalizing R&D

The process for capitalizing R&D has three steps:

• build and amortize the R&D asset using an appropriate asset life,
• make the appropriate upward adjustment on invested capital, and,
• make the appropriate upward adjustment on NOPLAT.

These adjustments can be applied to other expenses, such as an expansion of distribution routes.



Drawbacks of such adjustments

A couple of drawbacks of making too many such adjustments are

• the increased ability to manipulate short-term performance and 
• the incentives for managers not to recognize when to write down an asset created from a capitalized expense.

Reorganizing the Financial Statements

A proper assessment of financial performance requires reorganizing financial statements to avoid traps like double counting, omitting cash flows, and hiding leverage.



ROIC = NOPLAT / (Invested Capital)

FCF = NOPLAT + Noncash operating expenses - Investments in invested capital.

Invested Capital (for a simplistic firm)
= Operating Assets - Operating Liabilities = Debt + Equity

Total Funds Invested (for a more realistic firm)
= Invested Capital + Nonoperating Assets
= (Operating Assets - Operating Liabilities) + Nonoperating Assets
= (Debt + Equity) + Nonoperating Assets
= (Debt and Debt Equivalents) + (Equity and Equity Equivalents)


(NOPLAT is.Net operating profit less adjusted taxes)



In practice, there are difficulties in categorizing assets as operating or nonoperating and right-hand balance sheet items as debt or equity, and this makes computing the values in these equations difficult.

--------------------------------

Excess Cash

Excess cash should not be included in invested capital because it is not necessary for core operations, and including it will depress ROIC.

Financial subsidiaries

The operations of those subsidiaries require a separate analysis from those of the manufacturing operations, because financial institutions have different capital and leverage norms.

Advanced analytical issues

Advanced analytical issues include 

• operating leases, 
• pensions and other retirement benefits, 
• capitalized research and development, and 
• nonoperating charges and restructuring reserves.

Operating leases:  The implied value of those leased assets that are not capitalized can be estimated.  A more appropriate measure of leverage can be obtained with the following equation:

Asset Value at time t-1 = Rental Expense at time t / [kd + (1/Asset Life)]

Pensions and other retirement benefits:  Like excess cash, excess pension assets and pension shortfalls should not be included in invested capital.

Research and development:  Research and development should be included in invested capital.

Nonoperating charges and restructuring reserves:  Provisions fall into four basic categories:

• ongoing operating provisions,
• long-term operating provisions,
• nonoperating provisions, and,
• income-smoothing provisions.

Each requires an adjustment to return or invested capital or both.

Analysing Performance begins with an analysis of the Key Drivers of Value: ROIC and Revenue Growth.

The key drivers of value are:

• ROIC, and
• Revenue Growth.

The analysis of performance and competitive position begins with an analysis of these key drivers of value.

After having done that analysis, then do an assessment of the financial health of the firm to show whether it can make short-term and long-term investments



ROIC

It is useful to analyze ROIC with and without goodwill.


ROIC
= (1- Operating Cash Tax Rate) x (EBITA/Revenues) x (Revenues/Invested Capital)
= (1 - Operating Cash Tax Rate ) x EBITA / Invested Capital
= NOPLAT / Invested Capital



Revenue Growth

Revenue growth is one of the determinants of cash flows.

Organic revenue growth should be distinguished from growth derived from other factors such as currency effects, acquisitions, or divestitures.



-----------------------



Additional Notes:

Financial Ratios

A comprehensive model does a line item analysis, which converts every line in the financial statements into a ratio.

Ratios include common size entries computed in terms of assets or revenues for the balance sheet and income statement, respectively, and also days ratios found by the following general expression:

Days = 365 x (Balance Sheet Item / Revenues)



Efficiency Measures

Other measures provide insights into efficiency relative to other firms

One such expression is a breakdown of labour costs per unit:

Labour Expenses / Units of Output
= (Labour Expenses / Number of Employees) / (Units of Output/Number of Employees)



Power and danger of leverage

The following equation helps illustrate the power and danger of leverage

ROE = ROIC + [ROIC - (1 - T) x kd ] x D/E

T = tax rate
kd = cost of debt

It is important to note how the market debt-to-equity compares to peers in terms of the coverage and the level of risk the firm takes.

Conservation of Value and the Role of Risk. Increasing value through reducing the company's risk and its cost of capital.

Cash flow drives a firm's value creation.

Growth and ROIC generate cash flow.



Value creation

Companies create value:

• when they grow at returns on capital greater than their cost of capital or 
• when they increase their returns on capital.

Actions that don't increase cash flows over the long term will NOT create value, regardless of whether they improve earnings or otherwise make financial statements look stronger.

One Exception:  reducing the company's risks or its cost of capital can create firm's value

Actions the company takes to reduce a company's risk and therefore, its cost of capital.

There are different types of risk and it is important to explore how they enter into a company's valuation.

Only risk reductions that reduce a company's nondiversifiable risk will reduce its cost of capital.

How good is the company in creating value for its shareholders? How much value can it create?

The chief measures for judging a company are

• its ability to create value for its shareholders and 
• the amount of total value it creates.

Corporations that create value in the long term tend to increase

• the welfare of shareholders and employees 
• as well as customer satisfaction.

 They tend to behave more responsibly as corporate entities.


Value Creation

Value creation occurs when a company GENERATES CASH FLOWS AT RATES OF RETURN THAT EXCEED THE COST OF CAPITAL.

Accomplishing this goal usually requires that the company have a COMPETITIVE ADVANTAGE.

Strengthening its competitive advantage also creates value in the long run.



Activities that do not create value

Activities such as leverage and accounting changes do not create value.

Frequently, managers shortsightedly emphasise earnings per share (EPS).

• A poll of managers found that most managers would reduce discretionary value-creating activities such as research and development (R&D) in order to meet short-term earnings targets.
• One method to meet earnings targets is to cut costs, which may have short-term benefits but can have long-run detrimental effects.

Fundamental Principles of Firm's Value Creation

Value creation is determined by cash flows.

Cash flows are driven by 

• revenue growth and 
• return on invested capital (ROIC).

For any given level of revenue growth, increasing ROIC increases value.

However, increasing revenue growth does not always increases the firm's value.

• When ROIC is greater than the cost of capital, increasing growth increases the value of the firm.
• When the ROIC is less than the cost of capital, increasing growth decreases the firm's value.
• When ROIC equals the cost of capital, growth does not affect a firm's value.

The Stock Market is Smarter than We Think

The only 2 drivers of value creation are:

1. Return on Invested Capital (ROIC) 
2. Growth

Return on invested capital (ROIC) and growth are the only drivers of value creation.



Activities that do not drive value creation

Managers often spend time and resources attempting to:

• smooth earnings, 
• meet earnings targets,
• stay listed in a stock index,  
• become cross-listed,
• change the accounting rules, and 
• do stock splits.

The evidence shows that the stock market does not reward these efforts.  

Changes in accounting rules and stock splits do not have lasting effects.

ALL the above issues do not have an effect on stock returns unless they reflect a change in fundamental value.

Listing and delisting from an index and cross-listing

Listing and delisting from an index do not seem to have long-term effects for any given firm.

Although there can be a negative effect initially from delisting, the effect usually reverses in a few months.

Furthermore, cross-listing within developed markets does not have an effect; however firms in emerging markets may benefit from cross-listing in a developed market.



Accounting Changes

Investors apparently see through accounting changes.

If investors focused on earnings, for example, a move from FIFO to LIFO would lower the share price, but it generally does the opposite because of the increase in cash flows.

Another example, mere changes in goodwill do not affect share price; however, a change in goodwill that is associated with a real change in the firm produces a reaction from sophisticated investors.




Mispricing in the Market

Two possible sources of mispricings are:

1. the combinations of overreaction, underreaction, reversal and momentum, and
2. bubbles and bursts.

Unrealistic expectations of continued growth, which led to excessively high P/E ratios, caused the tech bubble in the late 1990s.

High earnings that were not sustainable caused the credit bubble a decade later.  In this case, it was not that the P/E ratios were too high, but that the earnings in the ratio eventually had to fall.

The basic source of value creation is competitive advantage. A High ROIC is the result of a Competitive Advantage.

A High ROIC is the result of a Competitive Advantage


The basic source of value creation is competitive advantage.

A high ROIC is the result of a competitive advantage from

• being able to charge a higher price or 
• being able to produce at a lower cost.

A strategy model for competitive advantage (Porter's framework)

A structure-conduct-performance framework provides a strategy model for competitive advantage.

One of the most widely used approaches in analyzing strategy is Porter's framework, which focuses on

• threat of entry,
• pressure from substitute products,
• bargaining power of buyers,
• bargaining power of suppliers, and,
• the degree of rivalry among existing competitors.

These forces differ widely by industry.



Five pricing advantages and Four cost advantages

Five pricing advantages and four cost advantages determine overall competitive advantage.

The five pricing advantages are:

• innovative products,
• quality,
• brand,
• customer lock-in, and,
• rational price discipline.

The four cost advantages are

• innovative business methods, 
• unique resources,
• economies of scale, and,
• scalable products/processes.

Pricing and cost advantages can erode through competition

In a competitive economy, the pricing and cost advantages can erode through competition.

The sustainability of the high ROIC from a competitive advantage depends on issues such as

• the length of the life cycle of the business and 
• the potential for renewing products.

Relative ROIC of a firm is fairly sustainable for periods of 10 years or more.

The evidence shows that the relative ROIC of a firm to the average of all other firms and to the firms in the industry remains fairly sustainable for periods of 10 years or more; however, there will be some reversion to the median and/or mean.




Additional Notes:


ROIC

=   NOPLAT / Invested Capital

= {(1- Tax Rate) * [Price per Unit - Cost per Unit]}/Invested Capital per Unit


NOPLAT = Net Operating Profit less Adjusted Tax

This formula explains how a higher ROIC is the result of a competitive advantage from being able to charge a higher price or being able to produce at a lower cost.

Return on Capital Employed

For example:

Capital employed $5 million
Annual profit after tax $1 million
Return on capital employed 20%

The profit may be expressed before or after tax.

Capital employed is the net amount invested in the business by the owners and is taken from the Balance Sheet.

Many people (including Warren Buffett) consider this the most important ratio of all.

It is useful to compare the result with a return that can be obtained outside the business.

If a bank is paying a higher rate, perhaps the business should be closed down and the money put in the bank.

Note that there are 2 ways of improving the return.  In the example above:

• the return on capital employed would be 25% if the profit was increased to $1.25 million.
• it would also be 25% if the capital employed was reduced to $4 million.

Cost leadership

Companies with large fixed costs and able to deliver their products most efficiently have a strong advantage and can achieve superior financial performance.

Firms don't usually advertise their cost structures per se.

To get an idea about how efficiently a company operates, look at its fixed asset turnover, operating margins, and ROIC - and compare its numbers to industry peers.

Is McDonald's Losing Its Economic Castle?

May. 17, 2015 6:35 PM ET  |  7 comments  |  About: McDonald's Corporation (MCD), Includes: BWLD, CBRL, ZOES

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Summary

• Is there really much to like about McDonald's anymore?
• Let's walk through its challenges, and whether it means the company's Economic Castle is deteriorating.
• We give our high-level thoughts on the turnaround plan and disclose our fair value estimate of shares.
• We also have some interesting ideas at the end of the article that many may be overlooking.

What in the world is an Economic Castle?

Berkshire Hathaway's Warren Buffett has popularized the concept of an "economic moat," perhaps best described in common language as sustainable competitive advantages. But an Economic Castle? Are we just confused?

In short, no.

Whereas economic moat analysis focuses on the duration of a company's economic profit stream, as measured by return on invested capital less the costs of which to attain that capital, economic castle analysis focuses on the magnitude of economic profit creation over the realizable near term.

Unlike the substantial duration risk inherent to predicting economic profits 20, 30 or more years into the future, the economic castle framework posits that the strongest performing companies during certain phases of the economic cycle will be those that generate the most economic value over the foreseeable future.

http://seekingalpha.com/article/3190106-is-mcdonalds-losing-its-economic-castle?auth_param=ii05t:1ali5us:13045f7ae0127a1efc301785d852f4b2&uprof=44

Investment in Giant Enterprises. But how successful are they from the standpoint of the investor?

Let us take a look at the top listed companies in the stock market with either the highest assets or highest sales.  All of these enterprises have achieved enormous size, and by that token they have presumably made a great success.

But how successful are they from the standpoint of the investor?

What do you mean by success in this context?

 "A successful listed company is one which earns sufficient to justify an average valuation of its shares in excess of the invested capital behind them."

This means that to be really successful (or prosperous) the company must have an earning-power value which exceeds the amount invested by and for the stockholder.


$$$$$$


It is evident from an analysis that the biggest companies are not the best companies to invest in, based on the percentage earned on invested capital.

It is equally true that small-sized companies are not suited to the needs of the average investor, although there may be remarkable opportunities in individual concerns in this field.

There is some basis here for suggesting that defensive investors show preference to companies in the asset range between $50 million and $250 million, although we have no idea of propounding this as a hard-and-fast rule.


Benjamin Graham
The Intelligent Investor

How to Pick Fundamentally Strong Stocks

Slow and steady doesn't make headlines, but the company can continue to earn excellent returns on invested capital.

CTB operates worldwide in the agriculture equipment field.  Berkshire purchased it in 2002 and by 2009, it has picked up six small firms.

Berkshire paid $140 million for the company.  In 2008, its pre-tax earnings were $89 million.

Vic Mancinellis, CEO of CTB, an agricultural equipment company, one of Berkshire's boring manufacturing businesses, exemplifies another reason for optimism.

Since Buffett bought CTB in 2002, it has earned roughly an average 11 percent annual return, compared to the S&P return of only 3 percent.

How can such a basic business produce eye-popping results?

It wasn't through financial innovations or game-changing acquisitions.   Instead, Mancinelli focussed on "blocking and tackling, day by day doing the little things right and never getting off course:"

Ten years from now, Vic will be running a much larger operation and, more important, will be earning excellent returns on invested capital.

But slow and steady doesn't make headlines.  Investors approaching the stock market continue to put their money in the hare, not the tortoise.

Betting on tortoises can create long-lasting wealth.

Growth can either ADD or DETRACT from an investment's value/

Growth in sales, earnings, and assets can either add or detract from an investment's value.

Growth can add to the value when the return on invested capital is above average, thereby assuring that when a dollar is being invested in the company, at least a dollar of market value is being created.

However, growth for a business earning low returns on capital can be detrimental to shareholders.  For example, the airline business has been a story of incredible growth, but its inability to earn decent returns on capital have left most owners of these companies in a poor position.

3 Investing Traps -- And How To Avoid Them

These tips should help you sidestep some common accounting pitfalls.

Alcoholics have 12 steps. Grievers have five stages. Investors have their phases, too, with the biggest leap coming when a fledgling shareholder begins tossing accounting ratios around. I've calculated ratios for years myself, both as a hedge-fund analyst and in making share recommendations for The Motley Fool, and I'll say this: ratios are both powerful and open to misuse by novices. I'd like to share a few tricks with you to help you avoid some common pitfalls.

Trap 1: Focusing too much on return on equity (ROE)

The much-vaunted ROE seems pure: take net profits, divide by shareholders' equity, and you see how efficient a business is with investors' money. ROE is Warren Buffet's favourite ratio, and executive pay is sometimes tied to it.

When it's a trap: When it's enhanced by debt. Borrowing funds to make more money for shareholders isn't necessarily evil, and is sometimes beneficial. But investors strictly watching ROE will miss the additional risk taken by a management team 'gearing up' to meet performance targets.

Protect yourself: Add return on invested capital (ROIC) to your arsenal. Using the same principle as ROE, ROIC essentially compares after-tax operating profits to both debt and equity capital, and thus provides a better measure of operational success that can't be inflated by a financing decision. Moreover, research by American equity strategist Michael Mauboussin of Legg Mason shows that companies whose ROICs either rise or remain consistently high tend to outperform others. Search online to find the precise formula, or drop me a comment in the box below.

Using Standard & Poor's Capital IQ database, I screened for companies with returns on capital (a near-identical cousin of ROIC) above 20% that have seen an improvement in return on capital during the past five years. These shares are not recommendations, but rather screen results that may be of interest given the discussion.

Company	Market cap (£m)	Return on capital
		Last fiscal year	Five years ago
Croda International (LSE: CRDA)	2,638	26.3%	22.8%
Renishaw (LSE: RSW)	1,053	25.1%	16.9%
Burberry (LSE: BRBY)	6,172	24.4%	20.0%

Trap 2: Taking turnover growth at face value

A sale is a sale, right? Wrong. Turnover is a prime line for accounts manipulation.

When it's a trap: Intricate shenanigans with turnover figures can be tough to uncover, but a simple rule of thumb is to become suspicious if growth in trade receivables (for instance, the amounts customers owe) meaningfully exceeds growth in revenues. This could indicate 'channel stuffing', whereby a company extends overly generous terms to customers simply to gain a short-term turnover boost.

Protect yourself: Using a screening tool or your own sums, compute the relative growth of both sales and trade receivables, particularly for companies whose growing turnover forms a major part of your investing thesis.

Again using Capital IQ, I noticed retailer Dunelm (LSE: DNLM) reported attractive 9% growth in sales last year (especially in this consumer market) -- albeit accompanied by a troubling 22% increase in trade receivables. While not a red flag outright, it's something to investigate further.

Trap 3: Using accounting profits to compute dividend cover

I've done this myself, and feel it's probably acceptable with stable companies clearly able to pay shareholders.

When it's a trap: The first thing a budding investor learns is that for accounting reasons, profits don't always match cash flow -- from which dividends are paid. Though cash flows and profits should theoretically match over time, profits are skewed by 'accrual' calculations, such as spreading the cost of equipment purchases over the life of the equipment, versus charging the costs in the year they occurred.

Protect yourself: Experienced analysts use free cash flow instead of reported earnings to produce a more reliable measure of dividend safety. Read this old-school Fool article for a moredetailed discussion on free cash flow. Swapping cash flow for accounting profits in your dividend cover calculation should increase its reliability.

Capital IQ turned up these companies as having cash flows materially exceeding accounting profits.

Company	Net profits (£m)	Free cash flow (£m)
Marks & Spencer (LSE: MKS)	603	701
Sage Group (LSE: SGE)	189	283
Rexam (LSE: REX)	154	265

There you have it. You're now three traps wiser, which is a step ahead of most investors. Indeed, while spotting numerical chicanery may be best for sidestepping share-price stinkers, avoiding losers is more than half the battle to building a winning portfolio.

http://www.fool.co.uk/news/investing/2012/02/02/3-investing-traps-and-how-to-avoid-them.aspx?source=ufwflwlnk0000001

ROE and ROIC

 Management is concerned about return on invested capital and return onshareholder equity and that's the focus. Everything else takes a backseat to that. 

The Mark of a Good Business: High Returns on Capital

The Mark of a Good Business: High Returns on Capital
Written by Greg Speicher on October 19, 2010

Categories: Buy Good Businesses, Warren Buffett

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

A good business is one that can earn very high returns on capital. Rarely can such a business invest all of its capital back into the business. One way to find companies that can is to look for companies that have grown book value at a high rate on a per share basis.

A business can still be a good investment if it can’t reinvest all of its earnings back into the business. An example is American Express. Prior to the 2008 economic crisis, Amex was earning over 30% on equity but was only reinvesting about a third of its earnings back into the business. The remaining two-thirds were paid out in the form of dividends and share repurchases.

There are numerous ways to measure return on invested capital. None of them is perfect. Any of the various metrics and ratios investors use to analyze a business are abstractions and, as such, typically tend to oversimplify the economic reality of the business. They are short-cuts we use to point us in the right direction so we can spend our precious time researching businesses that offer the most opportunity.

Return on Incremental Equity

I like to look at the total amount of equity that has been added to a business over the past decade and then calculate the return on that additional investment. This approach also allows me to calculate what percentage of the company’s earnings was reinvested, which in turn is useful in forecasting the future growth in earnings.

I typically use Value Line when I do this because the layout is very conducive to this type of analysis. It is one reason why investors like Buffett, Munger and Li Lu like Value Line.

It is useful here to remember Buffett’s reminder that it is not necessarily a cause for celebration if a business grows its earnings year after year. The same thing happens to a savings account if you add more capital each year, which does not make a savings account a good investment. It’s the return on this additional capital that determines whether something is a good investment or not.

To illustrate, let’s look at Johnson & Johnson (JNJ). In 2000, JNJ had shareholders’ equity of $18.8 billion. At the end of 2009, its shareholders’ equity had grown to $50.6 billion. We can calculate that, since 2000, JNJ invested $31.8 billion back into the business.

During that same time, earnings grew $8.1 billion, from $4.8 billion in 2000 to $12.9 billion in 2009.
By dividing the additional earnings of $8.1 billion by the additional $31.8 billion in capital, we can see that JNJ earned a return of 25.5% on its investment, which is very good.

It is also useful to look at what percentage of its total net earnings JNJ reinvested back into the business. The reason is that this is suggestive of how much of its future earnings JNJ is likely to reinvest. By multiplying the rate of reinvestment by the return on that investment, we can then calculate an expected growth rate for earnings.

Since 2000 through 2009, JNJ earned a total net profit of $89.7 billion. Since we already know that JNJ reinvested $31.8 billion over that same time period, we can calculate that JNJ’s rate of reinvestment is 35.5%.

If JNJ can continue to earn 25.5% on equity and reinvest 35.5% of its earnings, earnings should grow at about 9% (.255 x .355).

Keep in mind that this does not include dividends or share repurchases. The latter would cause earnings per share to grow at a faster rate. Also, it does not include an analysis of where JNJ is selling in relation to its intrinsic value which could have a material impact on the expected total return. Finally, this type of analysis works best with a stable business that enjoys durable competitive advantages, such as JNJ.

Another example is Southwest Airlines which is a successful airline that operates in the highly competitive and capital intensive airline industry. Between 2000 and 2009, Southwest’s shareholders’ equity increased by $2 billion. Earnings were $140 million in 2009 compared to $625 million in 2000 and have generally bobbed around over that time period. The return on that additional $2 billion has been relatively poor.

Calculating the return on incremental equity over a long-period of time should prove a useful tool in your analysis of prospective investments. Coupled with the rate of reinvestment, it can also allow you to get an idea of how fast a company can be expected to grow its earnings.


You can also use this approach to invert an expected rate of earnings growth to examine what combination of ROE and rate of reinvestment will be required to produce it.

In succeeding related posts, I’ll look at Buffett’s use of return on average tangible net worth and Greenblatt’s use of return on tangible capital employed to determine whether a business is good.

http://gregspeicher.com/?p=1660

----

The Mark of a Good Business: High Returns on Capital (Part 2)
Written by Greg Speicher on October 26, 2010 -
Categories: Buy Good Businesses, Warren Buffett

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett 1992 Berkshire Hathaway Shareholder Letter

Last week, I wrote a post that looked at return on incremental equity. The post explained a way to measure return on incremental equity over a multi-year period. It also considered how, in a stable business with a durable competitive advantage, the return on incremental equity and can be used, in conjunction with the rate of reinvestment, to predict the growth in earnings.

Today, I am writing about another tool used by Buffett to measure the returns on an investment: return on average tangible net worth.

Beginning with the 2003 Berkshire Hathaway letter to shareholders, Buffett began providing a simplified balance sheet of the manufacturing, service and retailing operations segment, a widely diversified group which includes building products, carpet, apparel, furniture, retail, flight training, fractional jet ownership and distribution.

Buffett breaks out the four broad segments of Berkshire – insurance, utilities, finance, and manufacturing, service and retailing operations – because they each have different economics which are harder to understand if considered as one undifferentiated mass. This is obviously useful to remember when analyzing a business with two or more disparate operating segments.

When he reports on the results of the manufacturing, service and retailing operations segment, Buffett focuses on the return earned on average tangible net worth, which for example in 2003, was in Buffett’s words “a hefty” 20.7%.

To calculate tangible net worth, take the equity on the balance sheet and subtract goodwill and other intangible assets. Buffett averages the tangible net worth that is on the books at the beginning and end of the year so as not to upwardly bias the return if the earnings were in part the result of a large injection of capital into the segment during the year.

On average, the segment enjoys very strong returns on average tangible net worth, typically in the low 20’s. This is highly meaningful because it not only shows the excellent economics of these businesses, but also it shows the returns that can be expected from additional capital that is invested into these businesses.

Here is the simplified balance sheet for the years since Buffett began providing it along with the calculations.
Here are some additional observations.

Buffett also provides the returns on Berkshire’s average carrying value. This is the same calculation as return on average tangible net worth without subtracting goodwill. Berkshire had to pay a substantial premium over book value to purchase these businesses given their excellent economics. Over the long-term, the return on incremental equity will be the major determinant of Berkshire’s returns on these investments as the retained earnings become an ever larger portion on the capital employed. As an investor, you want to pay close attention to both the premium you pay to buy a great business and the returns on incremental capital.

Omitting goodwill and intangible assets from the equation is appropriate because Berkshire will not need to pay a premium on incremental capital employed in the existing businesses. Berkshire does, however, need to pay a premium going forward to acquire businesses to add to this segment. This is evident from the goodwill and intangible assets line item which has grown from $8.4 billion in 2003 to $16.5 billion in 2009. Overall, to put that in context, Buffett invested an additional $15 billion in that segment over the same time period.
In analyzing an investment, you want to consider whether future growth will come from acquisitions, in which case you can expect additional goodwill, or organic investment, in which case the returns on tangible net worth would be a more appropriate metric.


Unfortunately, from the standpoint of providing opportunities for Berkshire to deploy capital going forward, some of Berkshire best businesses, which are found in this segment, are both small in scale as compared to Berkshire as a whole and require very little incremental capital.

Finally, it is fairly clear that this segment’s earning power has been materially impacted by the recession. If it is able to return to pre-recession levels, this group should earn net income of approximately $3 billion.

http://gregspeicher.com/?p=1708

Return on Equity and Invested Capital (Graphic)

http://yahoo.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHTML1?SessionID=s0MYW0RaIQfzvKB&ID=5187822