**Return on Equity
or Return on Capital**
Which is the better guide to performance?
by John Price, Ph.D.
www.sherlockinvesting.com
Two brothers, Abe and Zac, both inherited $10,000 and each
decided to start a photocopy business. After one year, Apple,
the company started by Abe, had an after-tax profit of $4,000.
The profit from Zebra, Zac’s company, was only $3,000.
Who was the better manager? For simplicity, suppose that at
the end of the year, the equity in the companies had not changed.
This means that the return on equity for Apple was 40% while
for Zebra it was 30%. Clearly Abe did better? Or did he?
There is a little more to the story. When they started their
companies, Abe took out a long-term loan of $10,000 and Zac
took out a similar loan for $2,000. Since capital is defined
as equity plus long-term debt, the capital for the two companies
is calculated as $20,000 and $12,000. Calculating the return
on capital for Apple and Zebra gives 20% (= 4,000 / 20,000)
for the first company and 25% (= 3,000 / 12,000) for the second
company.
So for this measure of management, Zac did better than Abe.
Who would you invest with?
Perhaps neither. But suppose that the same benefactor who
left money to Abe and Zac, also left you $100 with the stipulation
that you had to invest in the company belonging to one or
other of the brothers. Who would it be?
Most analysts, once they have finished talking about earnings
per share, move to return on equity. For public companies,
it is usually stated along the lines that equity is what is
left on the balance sheet after all the liabilities have been
taken care of. As a shareholder, equity represents your money
and so it makes good sense to know how well management is
doing with it. To know this, the argument goes, look at return
on equity.
Let’s have a look at your $100. If you loan it to Abe,
then his capital is now $20,100. He now has $20,100 to use
for his business. Assuming that he can continue to get the
same return, he will make 20% on your $100. On the other hand,
if you loan it to Zac, he will make 25% on your money. From
this perspective, Zac is the better manager since he can generate
25% on each extra dollar whereas Abe can only generate 20%.
The bottom line is that both ratios are important and tell
you slightly different things. One way to think about them
is that return on equity indicates how well a company is doing
with the money it has now, whereas return on capital indicates
how well it will do with further capital.
But, just as you had to choose between investing with Abe
or Zac, if I had to choose between knowing return on equity
or return on capital, I would choose the latter. As I said,
it gives you a better idea of what a company can achieve with
its profits and how fast its earnings are likely to grow.
Of course, if long-term debt is small, then there is little
difference between the two ratios.
Warren Buffett is well known for achieving an average annual
return of almost 30 percent over the past 45 years. Books
and articles about him all say that he places great reliance
on return on equity. In fact, I have never seen anyone even
mention that he uses return on capital. Nevertheless, a scrutiny
of *The Essays of Warren Buffett* and Buffett’s
*Letters to Shareholders* in the annual reports of
his company, Berkshire Hathaway, convinces me that he relies
primarily on return on capital. For example, in one annual
report he wrote, "To evaluate [economic performance],
we must know how much total capital—debt and equity—was
needed to produce these earnings." When he mentions return
on equity, generally it is with the proviso that debt is minimal.
If your data source does not give you return on capital for
a company, then it is easy enough to calculate it from return
on equity. The two basic ways that long-term debt is expressed
are as long-term debt to equity DTE and as long-term debt
to capital DTC. (DTC is also referred to as the capitalization
ratio.) In the first case, return on capital ROC is calculated
from return on equity ROE by
ROC = ROE / (1 + DTE),
and in the second case by:
ROC = ROE ´ (1 – DTC).
For example, in the case of Abe, we saw DTE = 10,000 / 10,000
= 1 and ROE = 40% so that, according to the first formula,
ROC = 40% / ( 1 + 1) = 20%. Similarly, DTC = 10,000 / 20,000
= 0.5 so that by the second formula, ROC = 40% ´ (1
– 0.5) = 20%. You might like to check your understanding
of this by repeating the calculations with the results for
Zac’s company.
If you compare return on equity vis à vis return on
capital for a company like General Motors with that of a company
like Gillette, you’ll see one of the reasons why Buffett
includes the latter company in his portfolio and not the former. |