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
NOPAT = Net Operating Profit After Tax
NOA = Net Operating Assets
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.
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.