QUALIPORT
Incremental Return On Equity

By Maynard Paton (TMFMayn)
April 22, 2002

Warren Buffett once said:

"Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite -- that is, consistently employ ever-greater amounts of capital at very low rates of return."

So how can investors detect a business that can employ "incremental capital at very high rates of return"? The trick is to use the incremental return on equity calculation, and not get misled by the more traditional return on equity ratio.

Like most things in investment, it's all best explained with an example.

My New Business -- the Early Years

Let's say I've invented a new type of radio and discover I can manufacture my new model far cheaper than anybody else. I go straight into business and start my company with £1,000, to buy all the necessary equipment. Shareholders' equity, reflecting all the assets the company has bought, is thus £1,000.

It's a great business. I make £300 post-tax profits in the first year. My return on the initial investment is 30%. In other words, the company's return on its starting equity is 30%.

Pleased with the first signs of success, I re-invest all the profits back into the business at the start of the following year. I buy more equipment to increase my manufacturing output. The new equipment increases the company's asset base, or equity, to £1,300.

The new £300 of equipment produces an additional £90 of profit over the second year, a return of 30%. Also, during the second year, my original £1,000 of equipment generates another £300 profit, as it did the year before. Overall, I've made £390 in my second year in business.

I repeat the whole process again in the following year. Here's a summary of my company's history after year three. For simplicity, I'll report the return on starting equity, rather than the more commonly used return on the average equity employed through the year.

Year  Opening  Profit  Closing    Return on  
      Equity    (£)    Equity   opening Equity 
       (£)              (£)         (%)         

1     1,000     300    1,300       30.0
2     1,300     390    1,690       30.0       
3     1,690     507    2,197       30.0  

Growing Pains

At the start of the fourth year, sales of my radios are slowing. So, I quickly launch a new television to boost profits instead. Profits are reinvested evenly into the existing radio business, and my new television business.

Thus, at the start of the fourth year, I plough £254 (half of year three's £507 profit) into each of my two businesses. So, my radio subsidiary has assets of £1,944, and my television subsidiary now starts with assets of £254, taking total company equity to £2,197.

But in my haste to release a new product, I've forgotten to do my homework on televisions. There's too much competition in this market, and my new product only generates returns of 5%. So year four profits of £596 comprise £583 (30% return on £1,944) through radios and £13 (5% return on £254) from televisions.

Undeterred, I evenly split my eventual profits into each subsidiary at the start of years five and six as well. Here's how things turn out.

Year  Opening Equity       Profit        Closing   ROE 
     Radio  TV  Total  Radio  TV  Total   Equity  
                                          Total            

4    1,944  254 2,197   583   13   596     2,793   27.1
5    2,241  551 2,793   672   28   700     3,493   25.1
6    2,591  901 3,493   777   45   822     4,315   23.5 

Trouble Later On

The going gets really tough in year seven. A big competitor has set up in the radio industry and my profits stagnate, but the assets required to produce my radios still produce a 30% return. So, I concentrate heavily on the television business and my profits are diverted totally to reinvestment in this area.

So, the start of year seven sees me invest all the prior year's profit of £822 into the television subsidiary, boosting its asset base to from £901 to £1,724 I make a 5% return again from this equity, and another 30% from the now static radio asset base of £2,591. It gives me a total of £864 profit.

The same reinvestment strategy is made for the following three years. Here's how things turn out.

Year  Opening Equity       Profit        Closing   ROE
     Radio  TV  Total  Radio  TV  Total   Equity 
                                           Total             

7   2,591 1,724 4,135   777   86   864    5,179    20.0 
8   2,591 2,587 3,179   777  129   907    6,086    17.5 
9   2,591 3,494 6,086   777  175   952    7,038    15.6 
10  2,591 4,446 7,038   777  222 1,000    8,037    14.2  

Review Of My Business Returns

As you're no doubt aware, I gradually moved from investing in a very high return business to investing into a very low return business. Was this apparent from the calculated return on equity figures?

If you were to look at my business in year five, the calculations for return on equity still look impressive. My overall profit then was £700 with £2,793 invested at the start of that year. My return on starting equity was still a high 25.1%. Moving on to year ten, the return was still a fair 14.2%.

The trouble with this return on equity calculation, dividing profit by the total equity accumulated in the business, is that the performance of "historic" investment decisions can mask the performance of more recent ventures.

Going back through this example, the original £1,000 radio investment was still producing a £300 annual profit at year ten. This investment contributed 30% to the final year's overall profit. That's all well and good, but it was obvious that these great returns of yesteryear couldn't be reproduced subsequently.

Incremental Return on Equity

What counts is how the business has invested its profits over the last few years. To identify whether recent reinvestment decisions are generating adequate returns, the incremental return on equity should be calculated using this formula, where x is the reinvestment period in years. For example, to calculate the return on incremental equity for the last 3 years, use x = 3.

        Profit (year n) - Profit (year n - x)
---------------------------------------------------
Equity (end of year n) - Equity (end of year n - x)

The following table illustrates the incremental returns over one and three years for my business.

Year  Return on       Incremental Return on Equity
     Opening Equity      1 year        3 Years
         (%)               (%)           (%)

1      30.0                           
2      30.0              23.1      
3      30.0              23.1      
4      27.1              14.9           19.8
5      25.1              14.9           17.2
6      23.5              14.9           14.9
7      20.0               4.8           11.2
8      17.5               4.8            8.0
9      15.6               4.8            4.8
10     14.2               4.8            4.8

Note how the incremental returns fall much faster, and from a lower base, than the usual return on equity figures that appear to gently glide downwards. Indeed, the one year figures drop materially each time the proportion of profit going into each business alters.

The first three-year incremental figure that can be calculated, after year four, shows a result of under 20% when re-investment initially diverts away from the radio business. No doubt that calculation would raise an eyebrow to any shareholder who had got used to 30% returns at that point. The traditional return on equity figure at that time would have been a less understated 27.1%

Although the calculation slightly understates the true return, the incremental return on equity gives a great handle on the efficiency of recently reinvested profits. In summary, the incremental return on equity gives a far clearer and a very timely indication of possible profit re-investment underperformance.

Questions and comments to the Qualiport message board, please.

A version of this article was published in Janaury 2000