Warren Buffet, Oracle and SAP – Part One

Warren Buffet, CEO of Berkshire-Hathaway, articulates his acquistion strategy as, “Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital.  More specifically, Businesses earning good returns on equity while employing little or no debt

Sounds straightforward and reasonable.  However, the key question is  “What is the criteria an investor can use to determine that a business is earning good returns on equity while employing little or no debt?”

In this post, I will present (briefly) a methodology to address the above question. And in subsequent posts, I will analyze Oracle and SAP using this methodolology.  Broadly, this technique/methodology can be termed as “ROE Disaggregration”.  It is also a variant of  DuPont Analysis – that is frequently used by analyst to do cross-sectional analysis.

The premise of this methodology is that ROE (Return on Equity) is not a good indicator, since a company can actually use debt to improve ROE (we will see how in a minute).  And as Buffet pointed out, we would like companies to employ little or no debt.  So we will disggregrate the ROE into operational and non-operational (financial activities) parts:

ROE =  Operating Return + Non-operating Return

ROE = RNOA + (FLEV * SPREAD)

RNOA – Return on Net Operating Assets

Unlike ROE, the focus of RNOA (pronounced as Roh-na) is to measure how successful is company in generating profits from operational resources (eg, Cash, Inventories, Equipment, etc.).  RNOA is totally decoupled from the financing (non-operational activities of the company)

RNOA  =  NOPAT/Average NOA

where

NOPAT = Net Operating Profit After Tax

NOA  = Net Operating Assets

And,

NOA (Net Operating Assets) =  Operating Assets – Operating Liabilities

NOPAT = Operating Revenues – Operating Expenses (note:  all the non-operating items are excluded)

Clearly, with RNOA, we are measuring how much operating revenues can be generated by operating assets.  Note, we have to take Average NOA, since the numerator (NOPAT) comes from income statement which accounts for a period (one year), while the denominator (NOA) comes from balance sheet which reflects point-in-time snapshot of the company.

FLEV(Financial Leverage)

Roughly, FLEV = Avg NFO / Avg Stockholders Equity.

NFO = Net financial obligations  =  Financial Liabilities (Bonds Payable, Accounts Payable,etc.) –  Financial Assets (Investments in Marketable Securities, etc.)

FLEV is nothing but a measure of relative use of debt versus equity in the capital structure of the company.  And as we mentioned earlier, Buffet likes companies with “little or no debt”.  In other words, very low value for FLEV.

SPREAD

When you borrow capital (for eg, by issuing a bond), you put it to work in your core business.  Let us assume that your core operating business returns 20% and you can borrow money at 7%.  In this case, Spread is 13% (20 – 7). In other words, spread is the difference between return on borrowed capital and the cost of that borrowing. It can be expressed as:

SPREAD =  RNOA – NNEP

NNEP = Firm’s effective interest rate for it’s net financial obligation = Net Financial Rate = Net Financial Expense/Net Financial Obligation

In conclusion, ROE has two components:  Operating Return and Non-Operating Return.   RNOA is used to measure the operating return, while the non-operating part (financial activities) are measured as FLEV * SPREAD.   In the next post, I will show how we can use Balance Sheet and Income Statement (from 10-K) of Oracle and SAP and calculate these ratios/numbers.

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5 responses to “Warren Buffet, Oracle and SAP – Part One

  1. Great article, The concept of value investing has encouraged me to start a portal of value investing on the Indian stock markets. I am doing analysis of Low PE, High dividend yields, Low PB and Low PB with high returns. I would love to share anything which is common. I really appreciate the effort you have put in your blog.

  2. Very nice article Naren. I dont know much about the interest rates in U.S, but in India interest on debt can bring down the company on its knees in results time.

    There are couple of similar indicators which I look for during investing.
    1. Current Ratio = Current Assets / Current Liabilities
    2. Quick Ratio = (Current Assets – Inventory)/Current Liabilities
    3. Long term debt to equity ratio
    4. Operating margin %, Free cash reserve per share

    #1,#2, #3 given above helps in understanding the company’s debt factors in short term and long term. Ratio of 1-2 is considered to be normal. < 1 is considered to be unhealthy financial (though not bankrupt). Ratio of more than 4 or 5 means, the company is good financially but not investing on expansion (this can be a concern too..:) )

    PE, PB ratios depend on industry to industry. For instance, PE ratio would not work out for banks and telecom domains. For telecom its based on the number of consumers using it. So this ratio can not be applied all across industries.

    Overall, it is definitely safer to invest in nearly debt-free companies. But it would be interesting to keep a watch on their expansion plans if they are cash rich. 🙂

    • Rajesh –

      Thanks for your feedback….

      The interest rate for long-term debt is determined by the credit rating of the bond-issuing company. Oracle recently issued bonds at 3.75% coupon (or around that) to finance their Sun acquisition. I am not sure we can generalize that debt is bad or we should invest in debt-free companies, but we need to consider the proportion of debt compared to equity (financial leverage), cash flow from operations and liquidity/solvency ratios that you mentioned.

      However, does it make sense to finance acquisitions by debt? Oracle is aiming to be like IBM under TJ Watson Jr – a systems company. How did IBM become dominant player under TJ Watson Jr? Did they adopt the same growth-by-acquisition financed by debt strategy? Briefly, this is an interesting topic, that requires more research on my part and perhaps, a separate post.

  3. Pingback: Smart Computing and RNOA (pronounced Roh-na) « Beyond Headlines

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