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
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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
GlaxoSmithKline
£12.80½
Questor says BUY
The company has been suffering from patent expiries on some of its major products – but is refocusing its business away from "white pills/Western markets" to a more consumer-orientated and emerging market focused group.
The headline numbers suffered from generic competition to herpes treatment Valtrex in the US and the withdrawal of diabetes treatment Avandia from some markets.
Last year's figures were also boosted by one-off sales of influenza pandemic vaccines.
This meant third-quarter pre-tax profits were lower than last year – at £1.97bn, compared with £2.07bn, on revenues that rose 0.8pc to £6.8bn. These numbers were ahead of expectations.
However, when the effect of Valtrex, Avandia and flu are stripped out, revenue growth was about 6pc. This is significant, as it represents the core of the company's business in the future.
GSK remains a dividend play, with the shares yielding 4.7pc. The group raised its interim payment to 16p from 15p last year – it will be paid on January 6 next year and the shares trade ex-dividend for this payment on October 27.
The shares were recommended as a dividend play on October 29 last year at £12.51 and they are now 2pc higher than that level compared with a market up 12pc. Trading on a December 2010 earnings multiple of 11.6 times, falling to 10.4 next year, the shares are a solid yield play with growth potential