Superb businesses
Incremental returns that are enticing
This is a revised version of a post originally published November 22, 2020 and revised in Revision1 March 22, 2026 and again revised in Revision 2 today.
See >>>Revision 1 below for March 22, 2026 change:
See >>>Revision 2 below for today’s change:
I like to develop a good feel for the economic performance of companies I invest in. Economic performance carries with it a sense of how successful a company (and company management) are in producing economic benefits for the shareholders. It focuses on effective use of the capital invested in the company.
For economic performance some investors look for a five year record of increasing sales and earnings. They feel this track record is a good indicator that the company will continue to grow its sales and earnings. This is a mistake. It is an example of our human tendency to predict the future by extrapolating from the past; a case of mistaken inductive reasoning. It is driving while looking in the rear view mirror.
Growth per se is overrated. As Warren Buffett has said: ‘’Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other works, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” (Buffett/Cunningham, 1998) p86. (Emphasis added)
A reminder
Successful investing does not lend itself to the mindless application of formulas or ratios. The performance indicators I look at here and in the Motherlode are tools to help direct and focus the mind. As Warren Buffett tells us, our job is to carry out a business analysis, not a security analysis. A business analysis is as much, if not more, a qualitative analysis: as compared with a quantitative analysis. It must be done with common sense and business sense. We must always remain skeptical of the numbers. As Warren Buffett put it in his 1986 Chairman’s letter: “…accounting is but an aid to business thinking, never a substitute for it.”
In the most generic sense, return on capital (ROC) is the profit earned by the business divided by the total of financial capital employed in the business and expressed as a percent. The financial capital is comprised of both debt capital and equity capital.
We can set out the formula which I think best captures what we are trying to measure:
Return on capital (ROC) = net income/capital employed (as a percent)
For ‘net income’ some analysts use Net Income as defined by the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), i.e. Net Income Attributable to Common Shareholders. Some analysts use adjusted net income, excluding certain one-time items. Some don’t use net income from the company’s statement of operations. Instead they use earnings before interest and taxes (EBIT); and, some use net operating earnings after taxes (NOPAT). For present purposes we don’t need to think about these differences, just be aware they exist. They are discussed elsewhere in the Motherlode. See here. As well, in an age of company investment in intangibles of lasting value that are expensed against reported income and do not appear on balance sheets we need to be alert to serious problems in taking reported assets and the book value of equity, at face value. For a discussion of this issue, see here and here.
Anyway, to start our assessment of economic performance we need a figure for ROC. This is available from various services including sell side analysts.
Cost of Capital (WACC)
It is nice to know from ROC percentages how profitable a company is relative to its peers. But, we want to know more than that. A substantial spread between ROC and a company’s cost of capital over an extended period of several years and through business cycles is usually indicative of a sustainable competitive advantage; in other words, a moat. It is also likely to indicate a company with potential to produces substantial Owner Earnings and opportunities to reinvest excess capital at high rates of return.
Economic performance is thus measured by examining the sustainable ROC of a company and subtracting from it the company’s cost of capital. Since companies have both equity capital and debt capital, we need to understand a company’s Weighted Average Cost of Capital (WACC). It is weighted between equity and debt depending on the proportion of each.
Understanding the WACC is useful for both investors and management. In order to determine the advisability of capital projects many corporations use a rule of thumb that the return on the capital for projects should significantly exceed the company’s cost of capital – that is, the cost to the company of raising capital in the market. For investors the company’s overall sustainable ROC compared with its WACC is really useful in identifying superb businesses.
>>>Revision 2: Since writing the above I have come on this quote from Warren Buffett about Cost of capital from the 2003 Berkshire Hathaway AGM
“The question about a discount rate, when you talk about our cost of capital, that’s worth bringing up, because Charlie and I don’t have the faintest idea what our cost of capital is at Berkshire, and we think the whole concept is a little crazy, frankly. But it’s something that’s taught in the business schools, and you have to be able to answer the questions or you don’t get out of business school. But we have a very simple arrangement in terms of what we do with money—we look for the most intelligent thing we can find to do…. We measure alternatives against each other, and we measure alternatives against dividends, and we measure alternatives against repurchase of shares. But I have never seen a cost of capital calculation that made sense to me.” —Warren Buffett (2003)
When you put this together with concerns about calculation of ROIC itself in trying to assess sustainable competitive advantage by measuring the magnitude of the positive spread between return on invested capital (ROIC) and the weighted average cost of capital (WACC), one wonders whether this kind of quantitative analysis is all it’s cracked up to be. See my post The awkward link between Buffett’s moats and ROIC – Part ll
End of Revision 2<<<
Calculating WACC
As noted, a calculation of cost of capital requires a blending of the cost of both types of capital. The cost of the company’s bonds is straightforward enough. The calculation of the company’s cost of equity capital requires a formula to produce the risk-weighted rate of return required by equity investors in the company. In essence the formula will have to capture the idea that the cost of equity equals the risk free rate of return plus a premium expected for risk. It will be immediately apparent that this is the same concept as the equity risk premium discussed elsewhere. This is also a field that the Capital Asset Pricing Model (CAPM) has messed up.
As a brief introduction to this topic, consider the following quotes from Charlie Munger who is Warren Buffett’s partner at Berkshire Hathaway:
“Of course capital isn’t free. It’s easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital.” “A phrase like cost of capital means different things to different people. We just don’t know how to measure it. Warren’s way of describing it, opportunity cost, is probably right. The answer is simple: we’re right and you’re wrong.” “A corporation’s cost of capital is 1/4 of 1% below the return on capital of any deal the CEO wants to do. I’ve listened to many cost of capital discussions and they’ve never made much sense. It’s taught in business school and consultants use it, so Board members nod their heads without any idea of what’s going on.”
Fresh thinking on WACC
When a company’s stock is more volatile than the average stock in the S&P 500, the traditional finance theory view, based on the Capital Asset Pricing Model (CAPM), is that a company’s cost of equity is higher since the stock is considered more risky and thus raising equity would be more expensive. This is fundamentally flawed; volatility is not a valid proxy for risk. This approach causes the cost of equity capital to be calculated at more than it should be for some companies and less for others. It can perversely show a very high cost of capital for a company with a pristine balance sheet and solid sustainable earnings whose stock just happens to be volatile. It could borrow at cheap rates and if it did borrow, its cost of debt as part of the WACC would bring the total WACC down significantly. But, if its stock price is volatile its traditionally calculated WACC can be quite high.
An old buggy whip company playing out the string may be a very low volatility stock but it may be a high risk investment with a low price earnings ratio and its cost of equity capital should be correspondingly high.
If the CAPM is flawed, what can replace it? The best approach is to assess whether companies in general and relatively, the company in question, can raise money cheaply in public offerings. When shares are trading on the stock exchange at ridiculously high price earnings ratios, one could say the cost of equity is generally cheap. If our company is trading at a higher price to earnings ratio than the S&P 500 average, it would be raising equity cheaper than the market as a whole.
>>>Revision 1:
More on the cost of equity in WACC
Thinking about the cost of equity in a weighted average cost of capital has evolved. The CAPM is both backward looking and flawed. It is flawed because volatility is not a measure or proxy for risk. A recent article by Kevin Prall, CFA in the CFA Institute’s Enterprising Investor is titled What the Market Knows That WACC Doesn’t. It makes the case that a better measure of WACC can be estimated using market prices. It is called the market implied discount rate (MIDR).
As Prall defines it, MIDR is “the discount rate that equates expected future cash flows, based on consensus forecasts, to the current stock price. Unlike WACC, MIDR reflects the return investors are implicitly demanding, embedding their assessment of risk, credibility, and future performance.”
MIDR is forward-looking and adaptive
Interest readers can check out the article. In a nutshell Prall is saying: “Traditional finance relies heavily on backward-looking inputs. MIDR is forward-looking and adaptive, updating as expectations change. It exposes hidden risk premia, highlights misalignments between theory and market pricing, and anchors strategy in observable investor behavior.”
“The market is constantly signaling how it prices uncertainty. MIDR gives companies a disciplined way to listen and to respond.”
For my money, a market-based estimate of the cost of equity is far more reliable than a backward looking fatally flawed CAPM.
The forward-looking Equity Risk Premium (ERP) in this context
In this connection I invite readers to reflect on forward looking vs backward looking calculations of the ERP.
Aswath Damodaran tells us that: “The equity risk premium is an essential ingredient into almost every part of financial analysis, incorporated into hurdle rates in corporate finance, discount rates in valuation and in expected returns on equity in financial planning.”
Damodaran is a professor of finance at the Stern School of Business at New York University. His area of focus is corporate finance and equity valuation. He has been described as the world’s foremost expert on the subject of corporate valuation.
In a recent note he writes: “To counter the problems that I saw with historical risk premiums, I started estimating forward-looking equity risk premiums, by essentially backing out from stock prices and expected cash flows, the expected return (internal rate of returns) that markets were pricing into stocks.”
Damodaran’s discussion and support for a forward-looking ERP supports the idea that the cost of equity in a WACC calculation should also be forward looking and based on MIDR so as to reflect the return investors are implicitly demanding, embedding their assessment of risk, credibility, and future performance.
End Revision 1<<<
Putting numbers on it
This post has more or less scratched the surface. It has all been in aid of trying to develop a sense of how we identify the economic performance of companies. We have touched on ROC and WACC and what the concept of a company’s cost of capital is.
ROC numbers can be quite misleading. They can be unduly flattering to management. Companies with ROC percentages above 15 or 20 are worth looking at further.
In the interest environment at the date of this writing, a weighted average cost of capital (WACC) should range from say 6% to say 9% for the most financially strong companies to figures well over 10% and even over 15% for less financially strong companies. See elaboration here.
Conclusion
The purpose of this post has been to highlight the subject of economic performance and raise a few issues regarding its use. Hopefully when analysts are talking about Return on Capital (ROC) and Weighted Average Cost of Capital (WACC) readers will know what they are talking about and understand their uses and weaknesses.
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