Warren Buffett - Not all growth is equal. How to gauge sustainability

Key takeaways at the end

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Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.

Except for special cases [...], we believe a more appropriate measure of managerial economic performance to be return on equity capital.

1977 Shareholder letter

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.  In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.

1979 Shareholder letter

When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement. Retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign – with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest.

If the widget company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO’s reign, the praise for him may be well deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be withheld. A savings account in which interest was reinvested would achieve the same year-by-year increase in earnings – and, at only 8% interest, would quadruple its annual earnings in 18 years.

1985 Shareholder letter

* Bold emphasis added

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Key concepts and takeaways:

• Earnings growth vs. return on capital: In the finance industry, too much emphasis is placed on earnings per share ("EPS") growth. Monitoring quarter on quarter changes in EPS distracts investors from what truly matters. What you want to understand is how sustainable that growth is in the long-term. Investors should therefore pay attention to returns on equity ("ROE") or returns on capital employed ("ROCE" or "ROIC"). Definitions vary, principle is the same. You want to understand how much a company earns on capital that it invested to generate those earnings. If EPS growth of 5% is achieved by investing additional 10% of capital, return on capital goes down. This is not a good managerial result or basis for sustainable growth. There are few important considerations, see below.

• Impact of inflation: We have recently witnessed slightly elevated levels of inflation. Businesses that were able to pass on this inflation to customers through increased prices reported higher earnings (not necessarily higher margins as costs could have increased proportionally). Given the denominator of the ROCE formulae takes asset values from the balance sheet, returns have been temporarily elevated. This is because values of major assets (think property, plant, equipment) are typically backward looking (they indicate how much an assets was purchased for in the past) and do not reflect the replacement cost (how much would it cost to buy that asset today). This fact elevated ROCE for companies that postponed their capital expenditure or did not re-invest during this period.

• Impact of leverage: Public equity investors typically look at ROE. They are buying small fractions of a company that has capital structure (the mix of equity and debt) already in place and share price reflects market value of that equity. To understand what drives ROE, investors also look at ROCE or ROIC to understand the return on the underlying assets regardless of the capital structure, and benchmark it with ROCE of other companies. Lastly, higher leverage boosts ROE numerically but does not capture the elevated risk related to that leverage.

• EBITDA and ROCE: Calculation of ROCE should never be done with EBITDA in the numerator. Instead, it should be based on EBIT after tax. To understand why, see this post on EBITDA.

• Sustainability of ROCE: What numerical analysis does not capture is how sustainable will ROCE be in the long-term. Industries, sectors, products, and services with high ROCE attract competition. Investors need to understand competitive advantage that a company possesses to sustain high levels of ROCE. To partially mitigate this issue, investors would look at the long-term historical developments of ROE and ROIC to gauge sustainability. If there are large swings, beware!