Measuring economic performance
A poor workman blames his tools
A friend recently ask me what I thought of Texas Instruments (TXN). He said he was attracted by its high return on equity (ROE) and return on capital (ROC). Morningstar reports an average ROE over the last five years of over 50. It reports a return on invested capital (ROIC) over the last five years averaging over 35. For present purposes we don’t need to worry about the difference between ROC and ROIC.
Warren Buffett tells us: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. Many businesses would be better understood by their shareholder owners, as well as the general public, if the managements and financial analysts modified the primary emphasis they place upon earnings per share and upon yearly changes in that figure.” (The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham. 1998, p.170)
Both ROE and ROC measure management economic performance. With ROE we assess the skill of management in using the equity capital used in the business. The idea of ROC is to assess the return generated from the capital employed in the business, whether equity or debt. That is, we want to know about the skill of management in generating returns on the total capital whether it is made up of pure equity or mixed equity and debt.
After all, we want to invest in companies that earn a return on capital well in excess of the company’s cost of capital over an extended period of several years and through business cycles. This is usually indicative of a sustainable competitive advantage; in other words, a moat. Finally, high ROC companies tend to be companies that have opportunities to reinvest excess capital at high rates of return.
If we make profound errors in interpreting ROE and ROC, we can be fundamentally mistaken about the skill of management in running the business and also seriously mistaken in understanding the company’s business franchise.
By the way, ROC is very similar to Return on Invested Capital (ROIC) and Return on Capital Employed (ROCE). As well, some analysts use EBIT or NOPAT rather than Net Earnings to calculate ROC, ROIC or ROCE. For present purposes these differences don’t really matter. See note below.
An ROC of over 35 would be amazing
Figuring out a company’s cost of capital is not easy. One has to blend the cost of debt with the cost of equity. That will give you a weighted average cost of capital (WACC). Let’s just assume, for present purposes, that for a company like TXN a rough average figure for WACC based on conventional analysis might be in the range of 8%. So, if a company like Texas Instruments can regularly earn an ROE of over 50 and an ROC of over 35, it would be pretty outstanding. I do believe the conventional calculations of the cost of equity capital place the cost way too high. But that’s another story.
Too good to be true
Companies’ capital is made up of debt and equity. Most analysts calculating ROE and ROC use the reported debt and equity found on the balance sheet. This is what Morningstar does. This is a mistake. The equity portion is made up of two kinds of assets, tangible and intangible. The problem is that financial statements don’t do a very good job of capturing intangible assets.
Intangible assets are created by R&D and other company spending most of which is expensed thus reducing reported income. The intangible assets produced may be of limited life and should be capitalized and amortized over their useful life. Other intangible assets may be of very long life and may remain as valuable assets for years to come. The main thing for present purposes is that these intangible assets never appear on the balance sheet and hence are not taken into account in totting up the equity capital employed in the business. As a result, they are not taken into account in calculations of ROE and ROC.
We all know about accounting goodwill. It does appear on balance sheets when a company makes an acquisition for more than the book value of tangible assets. Some intangible assets do find their way onto balance sheets if they comply with special rules, but very few.
Warren Buffett has a thing he calls “Economic Goodwill”. Warren Buffett make a clear distinction between Economic Goodwill and what he calls, ‘spurious accounting goodwill.’ (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham. 1998) p.176. He defines economic goodwill as follows: “Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham. 1998) p.173.
Let’s think about the value of Texas Instruments. If the company were sold, would it sell for its book value? Currently its book value is some $21 billion. That included debt. If you were just buying common shares do you think you could buy them all for the $13 billion shown on the balance sheet? Of course not. The market cap of the company is about $160 billion. So, the question is: what is the value of the equity capital company management has to work with? Is it $13 billion or closer to $160 billion?
When Morningstar puts a fair value on a company they use a discounted cash flow analysis. They are trying to come up with a number that is comparable to what you would get by looking at the book value of the tangible assets and the intangible assets using Warren Buffett’s concept of Economic Goodwill. The fair value they come up with in a current report is pretty close to the market cap. So, they think the fair value of the tangible and intangible assets less debt is around the $160 billion mark. I.e. they say the company is trading at around the fair value of its equity capital.
So, the market puts a price on the equity of $160 billion. Morningstar puts a fair value on the equity of roughly $160 billion. So, management has $160 billion of equity capital at its disposal. It is generating a return on that equity capital of about 5%!
We rely on short hand measures like ROE and ROC at our peril. I find it better to analyse a company’s cash flows, maintenance capex, growth capex and free cash flow in real dollar terms and measure them against the true value of the capital management has use of.
In Millions of USD (Except for Per Share Items)
Dec 31, 2018 Dec 31, 2019 Dec 31, 2020 Dec 31, 2021
- (A) Total Equity 8,994 8,907 9,187 13,333
- (B) Total Debt 5,068 5,803 6,798 7,741
——— ———— ———- ———-
- (C) Total Capital per balance sheet 21,074
- (D) Net Income After Taxes
5,536 5,017 5,595 7,769
ROE (D)/(A) x100 58%
ROE per Morningstar 68.7%
ROC (D)/(A) + (B) x100
Or ROC (D)/(C) x 100 36.87%
(A’) Total Equity using Market Cap 160,500
ROE using Market Cap (D)/(A’) x 100 4.84%
ROC using Market Cap (D)/(A’)+(B) x100 4.61%
To dig into the subject of intangible assets, check out this post:
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