Teenage Warren Buffett and a friend bought a broken down pinball machine for $25. The friend, a future engineer, fixed the machine while Buffett convinced local barber shop owner, Frank Erico to let the two entrepreneurs put the pinball machine in his shop and split the profits with the owner. One week later, Buffett discovered that the machine collected $25 from patrons, enough to buy another pinball machine. Before long, Buffett had pinball machines in barber shops across Washington, D.C., where he lived at the time. A year later, he sold the pinball machine business for over $1,000.
Buffett, now 94, has spoken a lot about moats, or enduring competitive advantages. A business manager’s job is to protect and widen the business’s moat so that it “protects excellent returns on invested capital.” Great businesses produce high profits relative to capital required, like Buffett’s pinball machine business.
Return on capital (ROC) and return on equity (ROE) are measures of the efficiency with which a business uses its capital. You can’t tell how efficient a business is by its profits alone. If a business produces $1 million in annual net profits, but requires $100 million in capital–tied up in equipment or inventory, for example–that’s a capital inefficient business. In such a case, the owner would be better off selling the assets and investing the money elsewhere. However, a business which produces $1 million in annual net profits with only $2 million in capital–a 50% return–should be maintained and expanded as long as those returns continue.
Former hedge fund manager Joel Greenblatt, who produced a 50% annualized return over 10, wrote the bestselling book, The Little Book that Beats the Market. In his book, Greenblatt provides two important criteria with which to evaluate business investments: 1) cheapness and 2) quality. For cheapness, he uses earnings yield, which is the inverse of the price-to-earnings (P/E ratio). A business with a P/E of 10, or $10 in price for every $1 in earnings, has an earnings yield of 10% (1 divided by 10). For the second criteria, quality, Greenblatt uses return on capital.
“Purchase a business that can invest its own money at high rates of return rather than [purchase] a business that can only invest at lower rates. In other words, businesses that earn a high return on capital are better than businesses that earn a low return on capital.” – Joel Greenblatt, The Little Book that Beats the Market
What is Return on Equity
Return on equity is net income divided by shareholder’s equity. Net income is the profit a business generates after paying for all costs, including costs to deliver the product or service, employee costs, other administrative costs, taxes, interest, and non-cash costs such as depreciation. Shareholder’s equity is total assets less total liabilities.
A business can be cheap–low P/E–and low quality, due to a low return on equity (ROE). In such a case, the business is unlikely to produce a good long-term return for investors. For example, if the business has to use much of its profit to upgrade its equipment or buy slow-selling inventory, it can’t distribute those profits to shareholders or buy back shares when available cheap, both of which benefit shareholders. By increasing its assets, it increases shareholder’s equity–the denominator in the ROE formula–its ROE decreases.
Alternatively, if a business increases its net income without increasing its assets–such as by raising prices–its ROE increases. Those increased profits can be paid to shareholders or used in other ways that also benefit shareholders, such as buying back stock when the price is depressed. Eventually, such an efficient–high ROE–business is likely to see its P/E ratio increase because investors are willing to pay more for companies which efficiently manage their capital.
The formula for ROE we’ve used so far is net income divided by shareholder’s equity. Instead of net income, we can use alternative measures of profitability. We can use earnings before interest and taxes (EBIT), the measure favored by Joel Greenblatt. He uses EBIT, as opposed to net income, because “companies operate under different levels of debt and differing tax rates.” For the denominator, such as in Greenblatt’s ROC formula, we can use only tangible capital employed–deduct goodwill and other intangible assets before subtracting liabilities. His formula for ROC is EBIT divided by tangible capital employed. Lastly, before we depart this exhausting accounting discussion, it can make sense to calculate returns based on incremental capital added to the business–return on incremental invested capital (ROIIC). The idea is that the true measurement of business efficiency is how well it uses new capital added to the business–such as profits retained–as opposed to the returns it generates on previously generated capital. You use the same general structure, profits divided by some measure of assets, but only include new profits and new assets added during the time period you’re evaluating efficiency.
How to Use Return on Equity to Evaluate Your Business (and Investments)
Between 2012 and 2015, one of my businesses, Amazing.com, generated tens of millions of dollars in profit on very little assets. Its return on equity (ROE) was extremely high. Even then, I could understand that generating high returns on little capital is good, but I didn’t know that reinvesting profits in a business without high returns on incremental capital is bad. So, we plowed profits back into the business. We wasted millions.
If you own a business which earns high returns on capital, but can’t reinvest profits at high returns, invest excess profits elsewhere. Not all businesses can grow into huge companies. Some businesses are great, cash-producing machines at a moderate size, and should be left that way. Trying to force such a business to grow beyond its natural size destroys the wealth of shareholders–that’s you and any other owners of your company.
Start by evaluating the return on equity of your company. Pull the net income from the previous year and the shareholder’s equity figure from the balance sheet for the beginning and end of the previous year. For example, to calculate 2024’s return on equity, divide 2024 net income by the average of the beginning and ending shareholder’s equity ((period start + period end) / 2).
Then, examine how well your business has been able to absorb and reinvest incremental capital. Has new cash generated by the business produced 15-20%+ gains in net income, or has it been wasted on pet projects, poor hires, and failed growth campaigns? If your business can’t reinvest the profits it generates at a high rate of return, use that profit to pay off high-interest debt, invest in other businesses, buy index funds, or invest any other asset which produces a higher return.
Use the same return on equity (or return on capital)-focused approach to evaluate investments. Look at overall profitability, business quality, competitive advantages, and returns on capital. Over a long period of time, your return from an investment or business you own is likely to approximate the return on equity of the asset.
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