The Secret to Buffett-style Investing: Unlocking the Power of High Returns on Capital Part 2

In 1992, Warren Buffett, the CEO of Berkshire Hathaway, wrote in his shareholder letter that the best business to own is one that can employ large amounts of incremental capital at very high rates of return over an extended period of time. In this blog post, I'm going to break down how Buffett measures the returns on an investment and explain how it can be applied to your own investments. Last week, I wrote about the concept of return on incremental equity and how it can be used to predict the growth in earnings of a stable business with a durable competitive advantage. Today, I'm going to talk about another metric that Buffett uses: return on average tangible net worth. Starting in 2003, Buffett began providing a simplified balance sheet of the manufacturing, service, and retailing operations segment in his annual shareholder letter. This segment includes a wide range of businesses such as building products, carpet, apparel, furniture, retail, flight training, fractional jet ownership, and distribution. Buffett separates this segment from the other three broad segments of Berkshire Hathaway - insurance, utilities, and finance - because each segment has different economics that are harder to understand if considered as a single undifferentiated mass. When reporting on the results of the manufacturing, service, and retailing operations segment, Buffett focuses on the return earned on average tangible net worth. To calculate tangible net worth, you take the equity on the balance sheet and subtract goodwill and other intangible assets. Buffett averages the tangible net worth at the beginning and end of the year so that the return isn't upwardly biased by large injections of capital during the year. On average, this segment enjoys very strong returns on average tangible net worth, typically in the low 20's. It's important to note that Buffett also provides the returns on Berkshire Hathaway's average carrying value, which is the same calculation as return on average tangible net worth without subtracting goodwill. Berkshire Hathaway has had to pay a substantial premium over book value to purchase these businesses given their excellent economics. Over the long-term, the return on incremental equity will be the major determinant of Berkshire Hathaway's returns on these investments as the retained earnings become an ever larger portion of the capital employed. When analyzing an investment, it's important to consider whether future growth will come from acquisitions or organic investment. If it's from acquisitions, you can expect additional goodwill, whereas if it's from organic investment, the returns on tangible net worth would be a more appropriate metric. The key takeaway from this metric is that, as an investor, you should pay attention to both the premium you pay to buy a great business and the returns on incremental capital.