Companies Warren Buffett invested between 1998 and 2001 (Part 3)

Companies Warren Buffett invested between 1998 and 2001 (Part 3)


GPU Inc: This is a utility holding company that distributes electricity to 2 million people in New Jersey and Pennsylvania. It was serves 1.4 million customers in Australia. This is a Berkshire holding.
We believe Buffett started buying this stock in February of 2000, for around $25 a share, against a book value of $28.46 a share, dividend payout of $2.18, and 1999 per share earnings of $3.25 a share. Buffett's buying opportunity came when the cost of creating energy increased to more than GPU could charge its customers, which caused it to lose $1.74 a share in the second quarter of 2000. To increase rates, the company has to apply to Pennsylavania regulators. If the regulators don't increase rates, GPU will go out of business and the good people of Pennsylvania will go without power. As of May 2001, First Energy, another utility holding company, had made a bid of $36 a share for the company, and the wise regulators of Pennsylvania are considering giving GPU a huge rate increase.

Price paid: $25 a share
Dividend: $2.18 a share
Earnings: $3.25 a share
Book value: $28.46 a share


H&R Block: This company prepares income tax returns. It is currently expanding its financial services group.

HRPT Properties Trust: This is a REIT that focuses on commercial real estate. Its earnings are solid and it pays a dividend every year between $0.88 and $1.51 a share. It is presently repurchasing its shares. We believe Buffett has been buying this stock at a price rumored to be $7 to $8 a share, where it traded for much of 2000. At that price he is getting an initial return of between 12.5% and 20%. We might add that at that price it was considerably below its book value of $11.60 a share - a Grahamian value play? As of May 2001 you could still buy it at $8.90 a share.

Price paid: $7 to $8 a share
Dividend: $0.88 to $1.51 a share
Book value: $11.60 a share
Initial return: 12.5% to 20%


JDN Realty: This is a REIT that develops, acquires, leases, and manages shopping centres in 18 states. It has a book value of $14.80 a share and pays a dividend of $1.20 a share. We believe Buffett started buying its stock at around $9 a share. The book value represents real estate that has been depreciated and is worth far more than it is carried on JDN's books. Buffett bought the stock at an initial return of 13% ($1.20 / $9 = 13%) and as an asset play.

Price paid: $9 a share
Dividend: $1.20 a share
Book value: $14.80 a share
Initial return: 13%



Related articles:
Companies Warren Buffett invested between 1998 and 2001 (Part 1)
Companies Warren Buffett invested between 1998 and 2001 (Part 2)
Companies Warren Buffett invested between 1998 and 2001 (Part 3)
Companies Warren Buffett invested between 1998 and 2001 (Part 4)
Companies Warren Buffett invested between 1998 and 2001 (Part 5)

Companies Warren Buffett invested between 1998 and 2001 (Part 2)

Companies Warren Buffett invested between 1998 and 2001 (Part 2)

Aegis Realty: This is a real estate investment trust (REIT) that owns and manages three million square feet of shopping-center space. We believe Buffett was buying it in 2000 for around $8 to $9 a share. It pays a dividend of $0.96 a share and has a book value of $14.81 a share. This is an interest play that pays a 10% return and a Grahamian value play that's selling below book value.

Price paid: $8 to $9 a share
Dividend: $0.96 a share
Book value: $14.81 a share
Initial return: 10%


Dun & Bradstreet Corp: This sells business information about other businesses.. Buffett bought this in 1998 because it is a great company and it was about to spin off its lucrative Moody's Investors Services. In spin-offs, the market sometimes fails to fully appreciate the value of the whole divided into separate parts. This is a Berkshire holding, believed to have been purchased in 1999 before the spin-off for approximately $15 a share. As of May 2001, it trades at $27 a share. Moody's Investors Services was spun off on September 30, 2000, at $26 a share, and as of May 2001 it trades at $32 a share. On Buffett's original $15 investment in D&B he made $12 on the D&B side and $32 on the Moody's side for a total profit of $44, which equates to a 293% return on his original investment of $15. Where was the rest of Wall Street? Off chasing tech stocks, of course.

Price paid: $15 a share


First Data Corp: This company process those millions of credit card transactions. It's a fantastic business with which Buffett has long been fascinated. This is a Berkshire holding.
Buffett started buying it in 1998 during a fall contraction/panic sell-off that dropped its price down to $20 a share against earnings of $1.56 a share, which equates to an initial return of 7.8%. It's per share earnings had a 15% annual rate of growth. In May 2001 its stock was trading at $66 a share, which equates to a 48% compounding annual rate of return.

Price paid: $20 a share
Earnings: $1.56 a share
Initial return: 7.8%
Per share earnings annual growth rate: 15%


Furniture Brands International: Buffet probably saw this one in Value Line, did his scuttlebutt at the Nebraska Furniture Mart, and discovered that Furniture Brands International was the number one manufacturer of residential furniture in America. This is a Berkshire holding.
We believe that he started buying it in 2000 for around $14 a share against earnings of $1.92 a share, which equates to an initial return of 13.7%. Its per share earnings have been growing at an annual rate of 28%. This is a great business. Everyone buys furniture at some time or another, and FBI is there to sell it to them. It has been in business since 1921 and has strong earnings and great returns on equity and total capital. Over the years it has come to dominate its field. Buffett bought after the 1999 bubble burst. It didn't stay down long. By February 2001 it was trading at $25 a share, giving Buffett a quick 79% return on his money.

Price paid: $14 a share
Earnings: $1.92 a share
Initial return: 13.7%
Per share earnings annual growth rate: 28%



Related articles:
Companies Warren Buffett invested between 1998 and 2001 (Part 1)
Companies Warren Buffett invested between 1998 and 2001 (Part 2)
Companies Warren Buffett invested between 1998 and 2001 (Part 3)
Companies Warren Buffett invested between 1998 and 2001 (Part 4)
Companies Warren Buffett invested between 1998 and 2001 (Part 5)

Companies Warren Buffett invested between 1998 and 2001 (Part 1)

Companies Warren Buffett invested between 1998 and 2001 (Part 1)

These are companies Warren Buffett invested either personally, through his foundation, or through Berkshire Hathaway. Be aware that simply because Warren Buffett has made investments in these companies or they met his selective criteria doesn't mean he would buy them today. He bought when the price was right. Remember: You want to identify the company with a durable competitive advantage and then let the price of its shares determine when you pull the trigger. The right price may come tomorrow or it may come five years from now.

Also keep in mind that at times Mr. Market is wildly enthusiastic about some of these businesses and prices them high. On other days he will be very pessimistic about their prospects and price them low. You are interested in the days that Mr. Market is pessismistic, not the others.


Related articles:
Companies Warren Buffett invested between 1998 and 2001 (Part 1)
Companies Warren Buffett invested between 1998 and 2001 (Part 2)
Companies Warren Buffett invested between 1998 and 2001 (Part 3)
Companies Warren Buffett invested between 1998 and 2001 (Part 4)
Companies Warren Buffett invested between 1998 and 2001 (Part 5)

Return on Shareholders' Equity

Return on Shareholders' Equity

This measures profitability, specifically the percentage return that was delivered to a company's owners.

Why it is important

ROE is a fundamental indication of a company's ability to increase its earnings per share and thus the quality of its stocks, because it reveals how well a company is using its money to generate additional earnings.

• It is a relatively straightforward benchmark, easy to calculate, and is applicable to a majority of industries.
• ROE allows investors to compare a company's use of their equity with other investments, and to compare the performance of companies in the same industry.
• ROE can also help to evaluate trends in a business.

Businesses that generate high returns on equity are businesses that pay off their shareholders handsomely and create substantial assets for each dollar invested.

How it works in practice

To calculate ROE, divide the net income shown on the income statement (usually of the past year) by shareholders' equity, which appears on the balance sheet:

ROE
= net income/owner's equity

TRICKS OF THE TRADE

• Because new variations of the ROE ratio do appear, it is important to know how the figure is calculated.
  
• ROE for most companies certainly should be in double figures; investors often look for 15% or higher, while a return of 20% or more is considered excellent.
  
• Seasoned investors also review 5-year average ROE, to gauge consistency.
  
• A word of caution: financial statements usually report assets at book value, which is the purchase price minus depreciation; they do not show replacement costs. A business with older assets should show higher rates of ROE than a business with newer assets.
  
• Examining ROE with ROA (return on assets) can indicate if a company is debt-heavy. If a company owes very little debt, then it is reasonable to assume that its management is earning high profits and/or using assets effectively.
  
• A high ROE also could be due to leverage (a method of corporate fudning in which a higher proportion of funds is raised through borrowing than share issue). If liabilities are high the balance sheet will reveal it, hence the need to review it.
  

Return on Investment

Return on Investment (ROI)

This measures the overall profit or loss on an invesment expressed as a percentage of the total amount invested or total funds appearing on a company's balance sheet.

Why it is important

Like ROA or ROE, ROI measures a company's profitability and its management's ability to generate profits from the funds investors have placed at their disposal.

One opinion holds that if a company's operations cannot generate net earnings at a rate that exceeds the cost of borrowing funds from financial markets, the future of that company is grim.

How it works in practice

The most basic expressio of ROI is:

ROI = net profit / total investment

A more complex variatio of ROI is an equation known as the Du Pont formula:

ROI (Du Pont formula )
= (net profit after taxes/total assets)
= (net profit after taxes/sales) x (sales/total assets)

Champions of this formula, which was developed by the Du Pont Company in the 1920s, say that it helps to reveal how a company has both deployed its assets and controlled its costs, and how it can achieve the same percentage return in different ways.

For shareholders, the variation of the basic ROI formula used by investors is:

ROI
= [net income + (current value - original value) / original value ] x 100

For example, somebody invests $5,000 in a company and a year later has earned $100 in dividends, while the value of the shares is $5,200, the return on investment would be:

ROI
= [100 + (5,200 - 5,000) / 5,000 ] x 100
= [(100+200)/5,000] x 100
= 6%

TRICKS OF THE TRADE

• Securities investors can use yet another ROI formula: net income divided by shares and preference share equity plus long-term debt.
  
  
• It is vital to understand exactly what a ROI measures, for example assets, equity, or sales. Without this understanding, comparisons may be misleading or suspect. A search for "return on investment" on the web, for example, harvests everything from staff training to e-commerce to advertising and promotions!
  
  
• Be sure to establish whether the net profit figure used is before or after provision for taxes. This is important for making ROI comparisons accurate.

Return on Assets

This measures the company's profitability, expressed as a percentage of its total assets.

Why it is important

Return on assets (ROE) measures how effectively a company has used the total assets at its disposal to generate earnings. Because the ROA formula reflects total revenue, total cost, and assets deployed, the ratio itself reflects a management's ability to generate income during the course of a given period, usually a year.

The higher the return the better the profit performance. ROA is a convenient way of comparing a company's performance with that of its competitors, although the items on which the comparison is based may not always be identical.

ROA = net income / total asset

Variation of this formula

A variation of this formula can be used to calculate return on net asset (RONA)

RONA = net income/(fixed assets + working capital)

And, on occasion, the formula will separate after-tax interest expense from net income:

ROA = (net income + interest expense) / total assets

It is therefore important to understand what each components of the formula actually represents.

TRICKS OF THE TRADE

• Some experts recommend using the net income value at the end of the given period, and the assets value from beginning of the period or an average value taken over the complete period, rather than an end-of-the-period value; otherwise, the calculation will include assets that have accumulated during the year, which can be misleading.
  
  
• While a high ratio indicates a greater return, it must still be balanced against such factors as risk, sustainability, and reinvestment in the business through development costs. Some managements will sacrifice the long-term intersts of investors in order to achieve an impressive ROA in the short term.
  
  
• A climbing return on assets usually indicates a climbing stock price, because it tells investors that a management is skilled at generating profits from the resources that a business owns.
  
  
• Acceptable ROAs vary by sector. In banking, for example, a ROA of 1% or better is considered to be the standard benchmark of superior performance.
  
  
• ROA is an effective way of measuring the efficiency of manufacturers, but can be suspect when measuring service companies, or companies whose primary assets are people.
  
  
• Other variations of the ROA formula do exist.

Retained Earnings and the Market Value of the Company

Does the value added by Retained Earnings increase the Market Value of the Company?

Warren Buffett believes that if you can purchase a company with a durable competitive advantage at the right price, the retained earnings of the business will continuously increase the underlying value of the business and the market will continuously ratchet up the price of the company's stock. The key lies in the company's ability to properly allocate capital and keep adding to the company's net worth.

A perfect example, of this is his own Berkshire Hathaway, which in 1983 had a book value of $975 a share and was trading at around $1,000 a share. Eighteen years later, in 2001, it has a book value of approximately $40,000 a share and is tradinga t approximately $68,000. This means that Berkshire's book value has increased approximately 4,002% and the price of its shares by 6,874%. Warren grew the company's net worth by using the company's retained earnings to purchase whole or partial interests of other businesses with durable competitive advantages. As the net worth of the company grew, so did the market's valuation of the company, thus the rise in the price of the stock.

This is not true with the price-competitive business. It can retain earnings for years and still never show a real increase in the value of the company's stock. In 1983, General Motors had a book value of $32.44 a share and was trading at approximately $34. In 2001, General Motors' book value stood at approximately $36 a share and the price of its shares at around $55. All General Motors has to show for those eighteen years in business is a 10% increase in its book value and a 52% increase int he price of its stock.

All you have to do is review a company's historical increase or decrease in the price of its shares and the historical increase or decerease in the company's per share book value. Use at least a 10 year spread. A company with a durable competitive advantage will have an increasing share price and an increasing book value.

Remember, the ultimate goal is to buy on of these businesses at a time that it is suffering from some bad news situation that has caused the shortsighted stock market to send its stock price down. You are looking for a RECENT downturn in the price of a company's stock, not for a company whose stock price has done nothing over 10 years.

RORC provides a fast method of determining durable-competitive-advantage business

Return on Retained Capital, RORC is not perfect.

Be careful that the per share earnings figures you employ for this test are not aberrations, but rather are indicative of the company's earning power.

The advantage to this test is that it gives you, the investor, a fast method of determining

• whether it is a durable-competitive-advantage business that lets its management utilize retained earnings to increase shareholders' riches or
• whether it's a price-competitive business that is stuck allocating its retained earnings to maintain its current business.

Remember, this is just one of nine screens that you have at your disposal, so if you find yourself in a gray area, make certain to use the other screens to help you make a clear judgment.

Summary

Durable-competitive-advantage companies wield a one-two punch when it comes to allocating resources. They can better take advantage of retained earnings than price-competitive businesses, which over the long term will make their shareholders a lot richer than those who own stock in price-competitive businesses.

Price-competitive businesses are able to retain earnings, but because of the high costs of maintaining their businesses, they are unable to utilize them in a manner that will cause a significant increase in future earnings. This means that their stock prices end up doing little or nothing.


Also Read:
Return on Retained Capital
Return on Retained Capital Illustrated by Various Companies
Companies that can't profitably deploy retained earnings make lousy investments
RORC provides a fast method of determining durable-competitive-advantage business

Companies that can't profitably deploy retained earnings make lousy investments

By calculating the Return of Retained Capital RORC (click here: Return on Retained Capital Illustrated by Various Companies ), you can tell that H&R Block and Wrigley do an infinitely better job of allocating retained earnings than General Motors or Bethlehem Steel does.

• In fact, if you had invested $100,000 in General Motors stock in 1990 and sold it at its high in 2000, you would have had a net profit of $141,025, which equates to an annual compounding return of approximately 9.1%.
• If you had done the same with Bethlehem Steel, you would have had a loss of approximately $40,000.
• If you had invested $100,000 in Wrigley's in 1990 and sold out at its high in 2000, you would have had a net profit of $566,666, which equates to an annual compounding return of approximately 20%.
• With H&R Block you would have earned a net profit of $299,960, which equates to an annual compounding return of 14.8%.

So which stocks would you rather have owned from 1990 to 2000? The price-competitive businesses General Motors and Bethlehem Steel, or the durable-competitive-advantage businesses Wrigley's and H&R Block? It's not a tough choice.

Also Read:
Return on Retained Capital
Return on Retained Capital Illustrated by Various Companies
Companies that can't profitably deploy retained earnings make lousy investments
RORC provides a fast method of determining durable-competitive-advantage business

Resorts World Bhd

Business Summary

Resorts World Bhd engages in tourist resort business in Malaysia. It offers various leisure and hospitality services, which comprise gaming, hotel, entertainment, and amusement. The company's activities also include land and property development; time share ownership; renting of its apartment and part of its leasehold land; sale and letting of completed apartment units, and land and property; ownership and operation of aircrafts; the condotel, hotel, karaoke, leisure and entertainment, and show agent businesses; and golf resort and property development. In addition, it provides tours and travel related, training, property upkeep, cable car and electricity supply, offshore captive insurance, and water services. The company is based in Kuala Lumpur, Malaysia.

Fundamentals
* in millions
Company Basics
Exchange
Bursa Malaysia
Company Name
Resorts World Bhd
Stock Code
4715
Sectors
Consumer Discretionary
Paid Up Capital *
MYR 590.20
Par Value
- (as at 2008-12-31)
Market Cap *
MYR 16,643.50 (based on value of 2.8200 per share)

Performance (as at 2008-12-31) *

Total Assets:
MYR 9,422.90
Intangible Assets:
MYR 94.40
Revenue:
MYR 4,886.70
Earnings Before Interest and Taxes:
MYR 1,754.30
EPS (Basic) Inc. Extraordinary Items:
MYR 0.11
PE Inc. Extraordinary Items:
25.49
EPS (Basic) Exc. Extraordinary Items:
MYR 0.11
PE Exc. Extraordinary Items:
25.49
Net Income:
MYR 634.40 (2007: 1555m)
Dividends - Common/Ordinary:
MYR 299.45
Dividends - Total:
MYR 299.45
Goodwill:
-
Minority Interest:
MYR 7.30
Reserves:
-
Return On Assets:
6.73%
Return On Equity:
7.63% (2007: 18.97%)
Shareholder's Equity:
MYR 8,317.80

----

Historical 5 Yr PE 12.1 to 18.4 (EY 8.26% to 5.44%)
Historical 10 Yr PE 12.6 to 22.9 (EY 7.94% to 4.37%)
Present PE based on MR2.82 = 25.49
Earnings Yield = 3.92%
DY = 1.8% (MYR 299.45/MYR 16,643.50 )
ROTC = 634.40/( OE 8691.09 + LTL 90.56 + STL 0) = 7.22% (2007: 18.90%)

Between the end of 1998 and the end of 2007:

• total earnings were $1.177 a share,
• total dividends were $0.283 a share and
• retained earnings were $0.894 per share ($1.177 - $0.283) to add to its equity base.
• the company's per share earnings increased from 8.9c a share to 19.2c, the difference was 10.3c a share.
• return on retained capital/earnings RORC was 10.3/89.4 = 11.52%

Return on Retained Capital Illustrated by Various Companies

Company A:

In 1989, earned $1.16 per share.
Between the end of 1989 and the end of 1999:

• total earnings were $17.14 a share,
• total dividends were $9.34 a share and
• retained earnings were $7.80 per share ($17.14 - $9.34 = $7.80) to add to its equity base.
• company's per share earnings increased from $1.16 to $2.56.

Interpretations:

• We can attribute the 1989 earnings of $1.16 per share to all the capital invested and retained in the company up to the end of 1989.
• We can also argue that the increase in earnings from $1.16 a share in 1989 to $2.56 a share in 2000 was due to the company's durable competitive advantage and management's doing an excellent job of investing the $7.80 a share in earnings that the company retained between 1989 and 1999.
• If we subtract the 1989 per share earnings of $1.16 from the 1999 per share earnings of $2.56, the difference is $1.40 a share.
• Thus, we can argue that the $7.80 a share retained between 1989 and 1999 produced $1.40 a share in additional income from 1999, for a total return of retained capital of 17.9% ($1.40 / $7.80 = 17.9%).

Company B

In 1990, earned $1 per share.

Between the end of 1990 and the end of 2000:

• total earnings were $20.12 a share,
• total dividends were $10.57 a share and
• retained earnings were $9.55 per share ($20.12 - $10.57 = $9.55) to add to its equity base.
• the company's per share earnings increased from $1 a share to $2.90.

Interpretations:

• We can attribute the 1990 earnings of $1 per share to all the capital invested and retained in the company up to the end of 1990.
• We can also argue that the increase in earnings from $1 a share in 1990 to $2.90 a share in 2000 was due to the company's durable competitive advantage and management's doing an excellent job of investing the $9.55 a share in earnings that the company retained between 1990 and 2000.
• If we subtract the 1990 per share earnings of $1 from the 2000 per share earnings of $2.90, the difference is $1.90 a share.
• Thus, we can argue that the $9.55 a share retained between 1990 and 2000 produced $1.90 a share in additional income from 1990, for a total return on retained capital of 19.9% ($1.90 / $9.55 = 19.9%).

Company C

In 1990, earned $42.96 per share.

Between the end of 1990 and the end of 2000:

• total earnings were $42.96 a share,
• total dividends were $10.30 a share and
• retained earnings were $32.66 per share ($42.96 - $10.30 = $32.66) to add to its equity base.
• the company's per share earnings increased from $6.33 a share to $8.50.

Interpretations:

• This company kept $32.66 per shae of shareholders' earnings and allocated it so that per share earnings increased by $2.17.
• This equates to a return on retained capital of 6.6% ($2.17 / $32.66 = 6.6%).
• This is about what you would have earned had you left it in the bank.

Company D

In 1990, earned $0.82 per share.

Between the end of 1990 and the end of 2000:

• total earnings were $4.93 a share,
• total dividends were $0.80 a share and
• retained earnings were $4.13 per share ($4.93 - $0.80 = $4.13) to add to its equity base.
• the company's per share earnings had total losses of $7.48 a share.

Interpretations:

• This means that management had to spend $7.48 a share in additional sums that they either borrowed or took from earnings retained during prior years.
• Since this $7.48 in shareholder capital was depleted, rather than paid out as a dividend, this is added to the $4.13 in retained earnings, giving a total of $11.61 a share that was kept from shareholders.
• Between 1990 and 2000, the company's per share earnings decreased from $0.82 a share to $0.25 a share. We can argue that the decrease in earnings was caused by the company being a price-competitive business that sucks up capital but does nothing to increase shareholders' wealth.
• If we subtract the 1990 per share earnings of $0.82 from the 2000 per share earnings of $0.25 , the difference is a negative $0.57 a share.
• Thus we can argue that the $4.13 a share retained between 1990 and 2000 and the $7.48 depleted during this period produced zero additional income.
• The company is in a tough business (steel) in which to develop a competitive advantage.

Company A: H&R BLOCK

Company B: WM. WRIGLEY JR. COMPANY

Company C: GENERAL MOTORS

Company D: BETHLEHEM STEEL

Also Read:

Return on Retained Capital

Return on Retained Capital Illustrated by Various Companies

Companies that can't profitably deploy retained earnings make lousy investments

RORC provides a fast method of determining durable-competitive-advantage business

Return on Retained Capital

A simple mathematical formula measures the capital requirements of maintaining a company's competitive advantage and management's ability to utilize retained earnings to improve shareholders' wealth. In essense this calculation takes the amount of earnings retained by a business for a certain period and measures its effect on the earning capacity of the company.

With a durable competitive advantage the company will be able to use its retained earnings either to:

• expand its operations,
• invest in new businesses,
• and/or repurchase its shares.

All three should have a positive effect on per share earnings.

On the other hand, a price-competitive business would need to spend its retained earnings to maintain its business to the face of fierce competition from other companies in the same line of business, leaving little or nothing to invest in new operations and/or buying back its shares.

Companies that have a durable competitive advantage usually don't have to spend a high percentage of their retained earnings to maintain their operations. The key word here is maintain. In theory, the more durable a competitive advantage, the less a business has to spend to maintain it. Warren Buffett's perfect business would be one that spends zero on maintaining its competitive advantage. That would free every dollar it earns to be paid out as a dividend or reinvested in the business, which should, in theory, make its shareholders even wealthier.


Also Read:
Return on Retained Capital
Return on Retained Capital Illustrated by Various Companies
Companies that can't profitably deploy retained earnings make lousy investments
RORC provides a fast method of determining durable-competitive-advantage business

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

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.

Also Read:

1. Return on Total Capital (ROTC)
2. The Right Rate of Return on Total Capital (ROTC)
3. ROA of Banks, Investment Banks and Financial Companies
4. Using ROTC Where the Entire Net Worth of the Company has been taken out
5. ROTC, ROA, ROE and Buffett's Durable Competitive Advantage
   

Using ROTC Where the Entire Net Worth of the Company has been taken out

This is rare and can only happen if the earning power of the company is exceptionally strong. On occasion, a company has such a strong durable competitive advantage that its earning power allows it to pay out a portion or all of its entire net worth to shareholders.

• In this situation shareholders' equity decreases, which in turn causes the ROE to increase dramatically - often to 50% or better.
• When the entire net worth is paid out, it creates a negative net worth, which means that the company will not report a return on shareholders' equity even if it is earning a fortune.

Advo is the nation's largest direct-mail marketing company. Think of it as an advertising company. Its competitive advantage is that it is the biggest, the best, and the most cost effective at the direct-mail game. Advo was originally founded in 1929. Talk about durable! Until 1996 it had seen a long and steady growth of its per share earnings and had produced consistent returns on shareholders' equity in the 18% to 20% range. From 1986 to 1996 it carried zero long-term debt. That's right, zero debt. Then in 1996 it added $161 million in debt and paid it out to sharehodlers via a $10-per-share dividend. This effectively wiped out the $130 million in shareholders' equity that it carried on its books and replaced it with debt. Advo can do this because the earning power of the business is so strong and consistent. Few companies can do this, and those than can, almost without exception, benefit from some kind of durable competitive advantage.

In situations like this in which there is no net worth, you need to look at the return on total capital (ROTC). In 2000, Advo posted a 35% ROTC.

Historically, in these situations, Warren has only made investments in companies that show a CONSISTENT ROTC of 20% 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

ROA of Banks, Investment Banks and Financial Companies

Banks, investment banks and financial companies rely on borrowing large amounts of money that they hope to loan out at higher interest rates to businesses and consumers.

A company like Freddie Mac, which deals in residential mortgages, carries $175 billion in short-term debt and $185 billion in long-term debt. If your business is borrowing money at 6% and loaning it out at 7%, there is no way your return on total capital ROTC is going to even approach 12%.

In these instances, Warren Buffett likes to look at what the bank or finance company earned in relation to the total assets under its control. The rule here is, the higher the better. Anything over 1% is good and anything over 1.5% is fantastic.

Learning Point

With banks, investment banks, and financial companies, look for a consistent return on assets ROA in excess of 1% and a consistent return on shareholders' equity ROE in excess of 12%.


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

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 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

Return on Total Capital (ROTC)

Return on Total Capital (ROTC)

Total Capital = Long-Term Debt + Short-Term Debt + Equity

Return on Total Capital = Net Earnings / Total Capital

The calculation of ROTC is illustrated here: http://files.shareholder.com/downloads/SYY/654431717x0x226567/EC4E58FF-E488-4CBB-A19B-570745E81387/Non-GAAP%20ROTC%20calculation.pdf


It is important to note the numerator and the denominator used in calculating ROTC by various other groups.

• Value Line defines the return on total capital as "annual net profit plus 1/2 of annual long-term interest divided by the total of shareholders’s equity and long term debt." Shareholders’s equity is the net worth of the company.
• Some defines total capital as equity plus long-term debt.

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

Return of capital

Return of capital

A distribution of cash resulting from depreciation tax savings, the sale of a capital asset or securities, or any other transaction unrelated to retained earnings.

Return on Total Assets

Return on Total Assets

Abbreviated as ROTA, refers to a measure of how effectively a firm uses its assets.

Calculated by (income before interest and tax) / (fixed assets + current assets).

Return on Assets

Return on Assets

Abbreviated as ROA, refers to a measure of a firm's profitability, equal to a fiscal year's earnings divided by its total assets, expressed as a percentage.