Let’s briefly talk about two indicators, ROC and Equity Growth, that are useful when looking at the strength of a company. Both these tools, used by Warren Buffett, demonstrate how fast a company can grow the money it has to invest in itself.
Return on Capital (ROC)
There’s been a lot written about ROC’s more popular cousin Return on Equity (ROE). In a nutshell ROE tells you how much money a company can earn on each dollar that someone invests in it. Let’s say you gave Johnny $100 to invest and he returned to you $110. You would say his ROE was 10%.
However, ROE can be a little deceiving if loans, or debt, aren’t also taken into account. So what if you found out that Johnny had to borrow another $100 to earn that $10? Other than thinking him incredibly industrious, his ROE would still be 10% but his ROC would actually be a meager 5%. Not as impressive.
I always look for a company with a consistent ROC of at least 10% for the last 5-7 years (unless I’m speculating in a new company), because they’ve shown they know how to maximize every dollar they have at their disposal. And when the time comes for them to borrow money, they’ll send the ROE through the roof and make gobs of money for shareholders!
ROC = Net Operating Income [Profit] / (Total Assets – Current Liabilities)
NB: If you can’t find ROC on a financial summary, it is also sometimes referred to as Return on Investment (ROI) or Return on Investment Capital (ROIC).
Equity, or book value, tells us how much a company is worth if it were no longer a company. This is also known as liquidation value. Comparing book value to companies in different industries isn’t particularly telling, because industries that require expensive machinery or real estate would have much higher book values than companies that have more intellectual property. What is useful is looking at the growth rate in the book value. It demonstrates a company’s ability to accumulate money on an annual basis. Just like ROC, I look for a consistent Equity Growth of at least 10% for the last 5-7 years.
Equity growth usually doesn’t find its way onto free research sites, so you’ll have to do the leg work yourself. I calculate the Equity Growth rate for a period of time using the company’s Book Value Per Share or BVPS. I recommend building a calculator in Excel to help. Here’s the formula in Excel to use for a given period of years:
Equity Growth = RATE(# Years, 0, -(BVPS0), BVPScurrent)
If you were looking at the 5 year equity growth rate of a company, and let’s say the Book Value/Share 5 years ago was $1.25, and $5.10 today, your formula would look like this:
Equity Growth5 = RATE(5, 0, -(1.25), 5.10) = 32%
An important caveat about Book Value though. Book Value can fluctuate significantly if a company starts distributing dividends or distributes an unusually high dividend for the year. If you’re intrepid you can go ahead and just adjust the book value by adding back the portion of the dividend that is usually high. So if a company’s dividends for the last five years are:
$100mil, $120mil, $400mil, $160mil, $180mil
I would add $260mil to the book value for year 3 so that the dividends are relatively smooth. I know it’s kinda wacky, but seriously, this isn’t cheating! Because there are several ways to determine BVPS, I’ve added some links below to help with your calculations.
Rule #1 (review). By Phil Town.
Zooming in on Net Operating Income. Investopedia.
Return on Equity versus Return on Capital. By John Price. The Investment FAQ.
Book Value. Investopedia.
Ratio: Book Value Per Share. Investopedia.