HELP: Growth and ROTCE

[samthefirefly]

Hello everybody,

 

I've been reading a book analyzing some of the investments made by Warren Buffett, and there is a section I can't seem to understand regarding return on tangible capital. Hoping one of you brilliant minds can help me see what I'm missing.

 

In the section, the author introduces "return on tangible capital (ROTCE)", computing it as NOPAT/tangible capital. The business at hand has a high ROTCE (25%), which the author says "indicates a very high-quality business able to compound returns at a rate significantly higher than its cost of capital". This makes perfect sense, moving on...

 

The author then discusses how ROTCE is only truly relevant if the company is growing: "This is so because even if a business has a very high ROTCE, if it is not growing, it will not benefit from having to invest less than peers in growth".

 

Again, this makes sense to me. If business A has a 25% ROTCE and business B has a 10% ROTCE and both businesses invest $100 in capital, business A will obtain $25 of profits while B will only gain $10.

 

This is where the issue comes in. The author then explains that to arrive at a certain intrinsic value in the future, the business has to grow earnings at an annual rate of 3%. However, he mentions that a problem arises from the fact that "the aforementioned would be for a business that just grew three percent per annum without needing any costs to achieve this growth. For instance, See's Candies has a ROTCE of 25%, so if the business grows three percent, it will require roughly one-quarter of that amount to finance the growth (if one assumes that capital intensity for the marginal business is the same as for the overall business). Because of the requirement of growth capital, for a business like See's Candies, roughly a four percent growth rate rather than a three percent growth rate is required."

 

This just doesn't make sense to me. We established that a higher ROTCE is preferred when growing because the business will benefit from having to invest less than peers to grow. But based on the last paragraph, if the business grows 3% with a 25% ROTCE, it will require a quarter of the 3% (i.e. 0.75%) to fund that growth. Based on that, for a business that grows 3% with a 50% ROTCE, it will require half of the 3% (i.e. 1.5%) to fund that growth, which is a higher amount. And a business that grows 3% with a 10% ROTCE will require a tenth of the 3% (i.e. 0.3) to achieve the growth, a lower amount. This section seems to imply to me that a lower ROTCE would be better, which I don't understand.

 

I'm not sure if the author made a mistake or I'm missing something (most likely option), so truly hoping someone can help me out here (had trouble sleeping because I was thinking about this LOL)

[rranjan]

 

 

if the business grows 3% with a 25% ROTCE, it will require a quarter of the 3% (i.e. 0.75%) to fund that growth. Based on that, for a business that grows 3% with a 50% ROTCE, it will require half of the 3% (i.e. 1.5%) to fund that growth, which is a higher amount. And a business that grows 3% with a 10% ROTCE will require a tenth of the 3% (i.e. 0.3) to achieve the growth, a lower amount. This section seems to imply to me that a lower ROTCE would be better, which I don't understand.

 

 

If the business grows 3% with 25% ROTCE it will require (3*100)/25 = 3 * 4 = 12% of funds , not 0.75% of funds.

 

Similarly, if the business grows 3% with 50% ROTCE it will require (3*100)/50 = 3* 2 = 6% of funds.

 

Last, if the business grows 3% with 10% ROTCE it will require (3* 100)/10 = 3*10 = 30% of funds.

 

10% ROTCE is using 30% of funds

25% ROTCE is using 12% of funds

50% ROTCE is using 6% of funds

 

You can see that higher ROTCE will be better because fewer funds will be used for the same growth and more funds will be available to owners.

 

Hope you can sleep better tonight ;)

 

- Rohit

 

 

 

 

[samthefirefly]

 

 

if the business grows 3% with a 25% ROTCE, it will require a quarter of the 3% (i.e. 0.75%) to fund that growth. Based on that, for a business that grows 3% with a 50% ROTCE, it will require half of the 3% (i.e. 1.5%) to fund that growth, which is a higher amount. And a business that grows 3% with a 10% ROTCE will require a tenth of the 3% (i.e. 0.3) to achieve the growth, a lower amount. This section seems to imply to me that a lower ROTCE would be better, which I don't understand.

 

 

Hey! Thank you so much for your reply. What you're saying and the calculations you present make perfect sense to me and stay in line with the argument about a high IROIC. It also seems to make sense to me that a company can increase profits by $3 by investing $12 at 25%.

 

With that said, do you think the author made a mistake with this statement: "See's Candies has a ROTCE of 25%, so if the business grows three percent, it will require roughly one-quarter of that amount to finance the growth (if one assumes that capital intensity for the marginal business is the same as for the overall business)." If anything, it seems to me that it would require 4x to fulfill the RR you're speaking about (0.12=0.03/0.25)

If the business grows 3% with 25% ROTCE it will require (3*100)/25 = 3 * 4 = 12% of funds , not 0.75% of funds.

 

Similarly, if the business grows 3% with 50% ROTCE it will require (3*100)/50 = 3* 2 = 6% of funds.

 

Last, if the business grows 3% with 10% ROTCE it will require (3* 100)/10 = 3*10 = 30% of funds.

 

10% ROTCE is using 30% of funds

25% ROTCE is using 12% of funds

50% ROTCE is using 6% of funds

 

You can see that higher ROTCE will be better because fewer funds will be used for the same growth and more funds will be available to owners.

 

Hope you can sleep better tonight ;)

 

- Rohit

[bizaro86]

Yes, the author erred. That should have said "invest four times that amount,"

[rranjan]

 

 

if the business grows 3% with a 25% ROTCE, it will require a quarter of the 3% (i.e. 0.75%) to fund that growth. Based on that, for a business that grows 3% with a 50% ROTCE, it will require half of the 3% (i.e. 1.5%) to fund that growth, which is a higher amount. And a business that grows 3% with a 10% ROTCE will require a tenth of the 3% (i.e. 0.3) to achieve the growth, a lower amount. This section seems to imply to me that a lower ROTCE would be better, which I don't understand.

 

 

Hey! Thank you so much for your reply. What you're saying and the calculations you present make perfect sense to me and stay in line with the argument about a high IROIC. It also seems to make sense to me that a company can increase profits by $3 by investing $12 at 25%.

 

With that said, do you think the author made a mistake with this statement: "See's Candies has a ROTCE of 25%, so if the business grows three percent, it will require roughly one-quarter of that amount to finance the growth (if one assumes that capital intensity for the marginal business is the same as for the overall business)." If anything, it seems to me that it would require 4x to fulfill the RR you're speaking about (0.12=0.03/0.25)

If the business grows 3% with 25% ROTCE it will require (3*100)/25 = 3 * 4 = 12% of funds , not 0.75% of funds.

 

Similarly, if the business grows 3% with 50% ROTCE it will require (3*100)/50 = 3* 2 = 6% of funds.

 

Last, if the business grows 3% with 10% ROTCE it will require (3* 100)/10 = 3*10 = 30% of funds.

 

10% ROTCE is using 30% of funds

25% ROTCE is using 12% of funds

50% ROTCE is using 6% of funds

 

You can see that higher ROTCE will be better because fewer funds will be used for the same growth and more funds will be available to owners.

 

Hope you can sleep better tonight ;)

 

- Rohit

 

Looks a mistake to me.

[samthefirefly]

Thank you so much for your help! I can finally sleep again haha