My most recent article, What Is Intrinsic Value? Part Two (here), generated a fair amount of feedback from readers. More than anything else, I had people emailing me to discuss the calculations; thanks again to those who reached out – I hope it helped!
As I started thinking about that article, I realized that I glossed over what was being said in those calculations. Looking back, I think that was a mistake; those concepts are among the most important that I’ve run across in my time as an investor. Personally, it took me years before I really started to grasp just how important they truly were. For some readers, I think it would be worthwhile to devote an article to some of those concepts. I’m going to start the conversation by quoting the aforementioned article:
“At the time (1988), Coca-Cola had ~$8 billion in total assets and ~$3.3 billion in shareholder’s equity on the books. In the prior decade, KO had generated a mid-teens return on assets, in addition to a 25-30% ROE with limited use of leverage (~2.5x in 1988); ROE had fallen below 20% – and just barely – in only two of the fifteen years prior to 1988.”
Two quick definitions: return on assets (ROA) is equal to net income divided by average total assets; return on equity (ROE) is equal to net income divided by average shareholders’ equity.
If you pull up a balance sheet, you’ll see that “Assets = Liabilities + Equity”; the ratio of assets to equity (average assets / total average shareholders’ equity) is known as financial leverage. The financial leverage measure is our bridge between ROA & ROE: with a 10% ROA and 2.5x financial leverage ($2.50 of assets for each dollar of equity on the books), our ROE will be 25%.
Let’s think of a company with those characteristics: they have $100 in equity on the books, $250 in total assets (meaning that $150 of the assets are funded by liabilities), and earn $25 in net income; that links up with our 25% ROE ($25 / $100) and our 10% ROA ($25 / $250).
What happens when this company earns $25? Well, they have two options: return the cash to shareholders (for this discussion, just dividends), or retain it in the business. If they pay out the $25 as a dividend, and nothing else changes, they’ll earn $25 in perpetuity (forever): the value of assets and equity on the books won’t ever change, and neither will net income.
What about the other extreme – what if they retain the $25 in net income entirely and reinvest it in the business? Well, that additional $25 is all equity (an increase in net worth); as a result of reinvesting the funds (as opposed to paying a dividend), the dollar value of equity on the books increases to $125 (with the accounts balancing a $25 increase in cash and a $25 increase in equity; remember, our equation –Â “Assets = Liabilities + Equity” –Â must balance at all times).
Assuming our financial leverage ratio stays at 2.5x, we need to increase the amount of total assets on the books by $62.50 (to match $25 x 2.5); in addition to the $25 of cash we’ve just added, we can go out and raise the other $37.50 in debt to equal an incremental $62.50 in assets.
Now, if our business can still generate a 10% ROA and a 25% ROE, net income will increase from $25 to $31.25; the $6.25 increase in net income is equal to our $25 increase in equity multiple by our ROE ($25 x .25 = $6.25), or our $62.50 increase in assets multiplied by our ROA ($62.50 x .10 = $6.25).Those are the earnings generated from the reinvested capital.Ă‚
Take a second to look at these numbers: the jump from $25 to $31.25 is an increase of 25%. The growth rate is equal to the retention ratio (in this case, 100%) multiplied by the return on equity (and 25%); as you adjust those variables, your growth rates will start to change.
If you can retain 100% at a 25% ROE, as in our example, compounding quickly makes the numbers take off like a rocket: after a decade with our first scenario (100% dividends), you would receive $250 in dividends ($25 x 10 years), and still own a business earning $25 a year at the end of year 10; at a multiple of 20x (which I picked arbitrarily), that’s a total (undiscounted) value of $750 for our business ($25 x 20 + $250).
On the other hand, the business that could reinvest every last penny of earnings and maintain the original financials (10% ROA, 25% ROE) would be earning $233 a year after a decade (earnings of $25 in year 1 compounded at 25% a year for 10 years); the same 20x multiple would suggest that the business is worth $4,660 in the second scenario – or 6x as much as in the first scenario in just 10 years. (Both assume value in year 10, not discounted back to year zero; let’s avoid this topic for today)
The problem is that it’s very, very difficult to maintain anything near that level for even a decade, let alone for 20, 30 or 50 years. In the case of a company like Microsoft (MSFT), businesses like “Windows” and “Office” are few and far between; the company is sitting on roughly $100 billion in cash and equivalents / investments and has no prospects of reinvesting even a small percentage of those funds in businesses that are as attractive as those franchises (partly because that’s an extremely high hurdle to clear). Even under the most optimistic scenario, a business like Xbox never had a chance of even coming close to matching (what was at one time) the base.
That’s what I was addressing in the last article when I stated the following about Coca-Cola (KO):
“While soft on specifics, we’re pretty sure of one very important thing: there appears to be a long runway – meaning decades – of pretty strong growth in the company’s competitively advantage core business.”
To be clear, Coca-Cola hasn’t reinvested anywhere near 100% of its earnings – it has been more like 30%. But even at that level, the ability to reinvest at a 30% ROE for two or three decades can have a profound effect on earnings – and ultimately, the stock price. In the case of Coca-Cola, EPS has increased by more than 1,000% over the past twenty-five years.
As you think about these calculations, they’re most easily grasped (in my opinion) through DuPont Analysis. As you think about asset turnover and margins, it pushes you in the direction of asking the questions that truly impact intrinsic value long term (especially pricing power). I’ll need to write a detailed article on this topic at some point down the road.
Conclusion
Hopefully these concepts are starting to make some sense for investors who are unfamiliar with them. As I noted at the outset, I think grasping these ideas is critical to intelligently thinking about long term capital allocation. As the numbers above show, it also starts to become clear why Charlie Munger (Trades, Portfolio) was pushing Warren Buffett towards businesses like See’s Candy (a topic I’ve discussed in depth here).
One final note: those who didn’t read John Huber’s recent article on Wells Fargo (WFCÂ –Â here), which presents a 40-year example of these concepts, should take the time to do so when they have a chance; as is always the case with John, the article is very good.
If any of the above concepts or numbers are still unclear or appear incorrect, please let me know and I'll do my best to help / correct them.
