Darn it took me long enough to find this article... its a little commentary on Buffetology wedged in there about how ol' Warren justifies companies and their debt... any how here is the article, it probably wont hurt to read and consider his strategies.
________________________________________________________________
The Motley Fool - August 18, 1998 18:18
August 18, 1998/FOOLWIRE/ -- After checking into the Fool's most
popular message boards the other day, I discovered how popular the
Buffettology message board is. For those not familiar, Buffettology is a
book by the former daughter-in-law of Berkshire Hathaway (NYSE: BRK.A)
chairman Warren Buffett. The book attempts to explain how Buffett
determines value and identifies companies with superior economics and to
"show the mathematical models and equations Buffett uses to determine
the basic value and earnings potential..." of companies in which he and
Berkshire invest. Subtitled "The Previously Unexplained Techniques That
Have Made Warren Buffett the World's Most Famous Investor," the
individual investor world has snapped up this book, voracious in its
appetite for all things about Buffett.
In looking through the active commentary and analysis using these
"previously unexplained" methods, return on equity (ROE) is one
performance measure that is frequently used by those investors who have
read the book and are seeking to internalize. That led me to chapter 35
in the book, "Understanding Warren's Preference for Companies with High
Rates of Return on Equity." I was disappointed by what I found in the
chapter.
The reason is that not all rates of return on shareholders' equity are
created equal. Two companies generating the same 20% ROE can exhibit
very different economic characteristics. That's because ROE is far more
than just earnings divided into owners' equity. Ah no, it's far more
elegant than that. Return on equity is a function of three variables: 1.
Asset turnover, 2. Net margin, and 3. Financial leverage. As an
equation, ROE looks like this:
Revenues Net Income Assets
------------ x ------------- x ---------
Assets Revenues SE
(Note: SE = shareholders' equity. Both shareholders' equity and assets
should be averaged for the year rather than just using beginning
figures.)
There are three main financial levers for ROE, then. If you have a
business where your inventory management is poor and your margins show
that your products don't have pricing power or that you're just an
inefficient producer, then you can generate a high ROE by piling on the
debt. Let's look at how that works. If my company turns over its assets
once every two years (0.5 times every year) and shows a net margin of
3%, then I need a bunch of debt to get to an ROE of 20%:
Asset turnover of 0.5 x net margin of 0.03 x leverage of Y = ROE of 20%.
So, 0.015 x Y = ROE of 20%. And Y = 0.2 / 0.015, and finally, leverage =
13.3. For every dollar in equity, I have 13.3 dollars in assets. Put in
another way, for every dollar of assets, I have 7.52 cents in equity.
That sort of business might not last very long and really doesn't show
great economics. Does this satisfy Buffett's tests? It sure doesn't look
like the financial model of many of his longer-term investments, though
God only knows what he bought in his stricter "cigar butt" investing
days. What Buffett looks for is contained in the annual report every
year*, and you don't need a fancy new $30 hardcover book to learn this.
Buffett looks for "usinesses earning good returns on equity while
employing little or no debt."
The typical Buffett company is a high return on assets (ROA) company.
Whoa! Huh? What Buffett is saying about a high ROE with little or no
debt means that he wants companies generating a high ROA. This is
because ROA times leverage equals ROE. Dissecting the above three-part
equation, we can prove this:
Revenues Net Income
------------ x -------------- = ROA
Assets Revenues
By taking the common elements out of the above equation, ROA can be
expressed as we are used to looking at it: Net income divided by
(average) assets. Taking the same inputs we used above, the company's
ROA would equal 0.5 times 0.03, or 1.5% ROA. That sort of ROA is pretty
bad for all but the banks and other financial services companies. For a
consumer products company or a manufacturing company, it usually means
something is pretty wrong. With a high return on assets company, the
pathologically risk-averse management doesn't have to have any leverage
to generate a satisfying return on assets. But with a little bit of
leverage, the return on assets can be magnified into an excellent ROE
without endangering the safety or autonomy of the enterprise. We'll look
at some examples of this, including Berkshire's "Inevitables," tomorrow.
*Every year, there is an "advertisement" in the Berkshire annual report
in which Buffett and Vice-Chairman Charlie Munger solicit calls from
principals or their representatives of companies that are interested in
being purchased by Berkshire Hathaway. Berkshire is interested in
companies with more than $25 million in pre-tax earnings
|
