One of the primary metrics that we use to determine the quality of a business is the return that it earns on tangible capital (we refer to this as ROC). Tangible capital is the sum of net working capital and net property, plant and equipment. A high ROC generally indicates that a business benefits from barriers to entry because, if not, competitors would emerge – attracted by the high returns – and drive ROC down to a normal level. Such businesses have what Warren Buffett would refer to as a “competitive moat.” Barriers to entry can take varying forms: strong brand loyalty, large capital requirements, or proprietary technology, to name a few.
ROC is important because it relates to a company’s future growth. In theory, a business’ earnings growth in absolute terms is equal to the product of incremental capital employed (beyond what is necessary for maintaining the business’ current operations) and the return earned on that capital. The fastest growing businesses are ones which have both a high ROC and the ability to reinvest a large portion of their earnings. Such businesses are rare and often quickly soak up all the potential opportunities for growth. But even for businesses that are fully mature, ROC is extremely important.
Consider two businesses, call them Business A and Business B. Both earn $10 per share, but Business A does so with $20 per share of tangible capital (a 50% ROC) while Business B requires $100 per share of tangible capital to produce the same earnings (a 10% ROC). Both of them experience growth in demand for their products at a similar rate to that of business overall, say 2% annually.
In order to take advantage of the opportunity for growth, both businesses must increase their tangible capital by 2% (build 2% more factories, 2% more stores, or whatever the case may be). For business A, this means that they must set aside $0.40 per share from earnings, while Business B must set aside $2 per share. The result is that, by the following year, both businesses will have the same earnings ($10.20 per share), but Business A will have been able to distribute $9.60 per share to its owners while Business B is only able to distribute $8 per share. These earnings are what Buffett refers to as “owner earnings.”
In the above example, Business A would rightfully command a 20% premium to Business B with regard to multiple of GAAP earnings as well as a 400% premium with regard to tangible book value. This is why it is not enough to simply look at companies that trade at low multiples of earnings or book value. If they earn poor returns on tangible capital, those low multiples may very well be justified. This is precisely the lesson that Warren Buffett learned when he purchased the dying textile business, Berkshire Hathaway, at a price that seemed attractive.
He believed he had gotten a bargain because he paid less for the business than the book value of its assets. In fact, he had overpaid, and it soon became clear why: the business earned poor returns on capital due to being at a competitive disadvantage relative to lower cost producers, particularly those overseas. He would have to choose whether he wanted to invest more to keep the business afloat – thereby tying up an ever-increasing amount of his capital at rates of return lower than could be obtained elsewhere – or face declining earnings. As he would later explain, “Time is the friend of the wonderful company, the enemy of the mediocre.”