Unleveraged Return on Net Tangible Assets: It Only Matters When Coupled with Growth
The best way for you to understand unleveraged return on net tangible assets is to look at the reports in the Library section of Focused Compounding. I’m going to give you the basic formula for return on unleveraged net tangible assets here, but it won’t make as much sense as seeing the calculation for yourself by looking down each yearly column of the “datasheet” on one of the 20+ reports in the Focused Compounding library.
The definition of return on unleveraged net tangible assets is usually approximated as:
Earnings Before Interest and Taxes / ((Non-Cash Working Assets: Receivables + Inventory + Property, Plant, & Equipment – (Working Liabilities: Accrued Expenses + Accounts Payable))
You can then adjust that result by a tax rate of 35% (so, multiply it by 0.65) to get an after-tax figure for U.S. companies.
Again, It’s best for you to look at some sample reports that include this figure long-term. So, here is an example using Grainger.
It’s very important to stress two points:
1) Unleveraged return on net tangible assets is a useful indicator of the actual business’s day-to-day profitability. It ignores things like cash and goodwill because these things are not needed to run the day-to-day business; instead, they reflect past decisions by the board (to make high priced acquisitions or to hoard cash or whatever)
2) You only need to know what unleveraged returns on net tangible assets are within a certain range. Basically, pre-tax returns of worse than 15% are a problem (since, after-tax they can be less than 10% which is roughly the long-term return in the stock market) and pre-tax returns greater than 30% are always sufficient (because, after-tax returns would be 20% or better in that case which is – over the truly long-term – a better record of compounding wealth than all but a very small number of public companies).
What matters is the incremental return on the money retained by the corporation that could otherwise be paid out in dividends or used to buy back stock.
I think return on NTA is a very important number. However, I don’t think you should necessarily prefer a business with a 400% return on NTA over a business with a 40% return on NTA.
Let me explain why. But, first let Warren Buffett explain why:
“…growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation.”
– Berkshire Hathaway Shareholder Letter (2000)
Remember that last phrase “usually a plus, sometimes a minus”. Growth is usually good. But what’s always true is that whenever a company has a high return on net tangible assets – you as a shareholder want growth. And, whenever a company has growth – you, as a shareholder, want a high return on net tangible assets.
The combination is key.
Let’s put it into numbers. These are rough numbers. But, when scanning a company’s past history, I do find them useful.
When looking at pre-tax return on NTA (and a 35% U.S. corporate tax rate), you can basically assume that at a return on NTA of less than 15% a company’s growth is not a meaningful plus for you as an investor – and might actually be a minus. This is because you can – if you are a patient, selective investor – usually find things to do with the money the corporation you own pays out to you in dividends that will compound that money at 10% a year or better. Therefore, if return on NTA is 15% or less pre-tax (so 10% or less after-tax), it is better off being invested by you in a new stock rather than by the company in growing the business.
In fact, I would always have more faith in my own ability to earn 10% a year or better by finding a new stock than I would have in a business with a history of earning just a 15% annual pre-tax return on NTA retaining that money for me and clearing that same 10% compounding of wealth hurdle on my behalf.
That’s a bad news situation. We don’t want to see a pre-tax return on unleveraged net tangible assets below 15%. What do we want to see?
A pre-tax return on net tangible assets of 30% or higher would make all growth very valuable. This is because the after-tax return would be 20% or higher in this case. It is very difficult for you as an investor to find stocks that will return 20% a year for very long. You can find cheap stocks that return 20% for maybe 5 years at a time. But, it becomes difficult to find stocks that you can buy today and can return 20% a year for 20 years. In fact, it’s nearly impossible.
If this company had a repeatable formula for growth – for example, it was a restaurant or retail chain opening new stores as it expanded nationwide – I would actually prefer that such a predictable growth business making at least a 30% pre-tax return on its unleveraged net tangible assets keep every penny of earnings it could instead of paying out dividends to me or buying back its own stock. That’s because such a business can repeatedly make a 20% after-tax return on incremental investments. I can’t. I can sometimes find stocks that will return 20% a year. But, the stocks I can find that return 20% a year don’t do it for 10, 15, or 20 years. So, I need to constantly replace these ideas more like every 3 or 5 years to make returns as high as 20% a year. A repeatable business model doesn’t have to do that. It’s less risky to keep your money in a growing, high return on NTA business than trying to keep finding value stocks over and over again.
In broad strokes, here’s what we’re looking for.
It makes sense to avoid companies with:
* High growth and low returns on net tangible assets
And focus on companies with:
* High growth and high returns on net tangible assets
The best way, in fact, to think about return on net tangible assets is to invert it. Instead of thinking about returns on assets, equity, or net tangible assets – think about the “cost” of growth.
Assume two companies can both grow sales at 5% a year. How does return on net tangible assets matter here?
Most companies can only grow about 5% a year while paying dividends out that are half of earnings. In other words, they have to retain half their earnings just to grow about 5% a year.
A company with an infinite return on net tangible assets (because it has negative net tangible assets due to “float”) like Omnicom can pay out all of its earnings in dividends while growing 5% year.
So, let’s say both Omnicom and this other “normal” stock trade at a P/E of 15. A P/E of 15 is an earnings yield of 6.67% (1/15 = 6.67%).
So, Omnicom’s stock can return 11.67% a year when it trades at a P/E of 15 and grows sales by 5% a year, because it would be able to grow sales by 5% a year (and therefore intrinsic value) plus it would also be paying out 6.67% of your purchase price in some combinations of dividends and share buybacks. In fact, if Omnicom always traded at a P/E of 15 and always used all of its earnings to buy back its own shares, the company’s EPS growth rate could be as high as 12% a year while the company’s income was growing just 5% a year.
Compare this to a more typical business. It grows 5% a year. It trades at a P/E of 15. It has the same earnings yield of 6.67%. But, it has to retain half of this. So, it can only pay out a dividend yield plus share buyback rate of 3.33% to you. This means the stock will tend to return about 8.33% (5% growth rate plus 3.33% buyback/dividend yield).
So, two companies with the same P/E ratio (15) and the same net income growth (5%) could actually have returns for shareholders that differ by 3.33% a year. That sounds small. But, for a true buy and hold strategy – it would make a big difference. Over 30 years, a $1,000 investment in the “normal” type stock would grow to $11,000 (8.33% a year) while the same $1,000 investment in the Omnicom type stock would grow to $27,000 (11.67% a year).
So, really it is the inverse of return on net tangible assets (how much you have to add to NTA each year to grow earnings by a certain amount) that – when coupled with a company’s growth rate – is what matters.
A very high return on net tangible assets but no growth doesn’t do anything for you. For example, assume Omnicom grew its earnings at 0% a year and traded at a P/E of 15. In that case, it could only ever return 6% to 7% a year as a stock. It could pay out all of its earnings. But, it couldn’t grow that payout over time.
Now, take the other extreme. Assume a company can grow fast (let’s say 10% a year for a long time), but it only has a return on net tangible assets of 10% pre-tax.
Such a company would have to issue more shares of stock or take on debt just to grow. After taxes, a 10% pre-tax return on NTA would work out to be about 6.5%. This means the company would need to increase its assets by about $15 a share for every $1 a share it added to earnings.
For an example of a business that looks somewhat like this – though perhaps not quite as bad – look at Micron Technology (MU). The semiconductor industry has never had a shortage of growth during the 40 years or so Micron has been in business. However, Micron’s profitability has often been insufficient to fully support that growth internally. So, yes, the company has grown. But, shareholders have not gotten dividends or buy backs. In fact, Micron has sometimes taken on debt. The long-term (like 30-40 year) comparison between Micron and Omnicom illustrates that Micron has always had better growth prospects as a company and yet Micron shareholders have usually gotten worse returns and probably taken higher risk for those worse returns than Omnicom shareholders.
A company can grow and be a mediocre investment. It depends on how much money it needs to support its growth and where it gets that money from.
Where can that money come from?
It can only come from issuing more shares (the opposite of a stock buyback) which would cause the company’s 10% rate of growth in net income to now be higher than the EPS growth rate that shareholders get. For shareholders, issuing shares is like slowing down growth. Or, the company could borrow money from a bank, issue debt, etc. That can work for a time. And debt might be available at well less than 10% pre-tax. So, the company might be able to keep adding debt and keep paying the interest on that debt. The added leverage could benefit shareholders in the form of higher returns. But, it would also bring higher risks.
To reliably compound the size of your business – without adding debt or new shares – you really need to generate pre-tax returns on net tangible assets of about 15% or better. Cyclicality is also important here. A return on net tangible assets of 16% a year in every single year can actually be much better than a return that averages – in the sense of an arithmetic mean – some figure above 16%, but which has years below 16%. At the risk of getting overly mathematical here, what you always like to see is a harmonic mean that looks good not just an arithmetic mean. Or, more simply put, you want the lowest return on net tangible asset years to still be pretty good years.
My advice is to look for companies that generate a pre-tax return on net tangible assets higher than 15% in virtually all years.
In some industries, this is impossible. Hunter Douglas is a good business and the world leader in blinds and shades. However, it’s in the housing industry and about 50% of its sales come from the U.S. From 2008-2012, Hunter earned just a 9% to 14% return on net tangible assets before taxes. This works out to be about 6% to 9% after-taxes. That’s an unacceptable rate of return. However, net tangible assets actually decreased during this period. So, the incremental return on net tangible assets – what Hunter earned on the earnings it retained from shareholders during those years – was actually better than it appears.
The worst thing you can see is when a business keeps growing net tangible assets while having insufficient and worsening returns on net tangible assets.
The best business in the world would be something like Omnicom (or any ad agency). It can grow and pay out 100% of earnings at the same time.
The second best business in the world would be something like a successful restaurant chain or retailer. It can grow while earning more on its money (a pre-tax return on NTA greater than 30% a year) than you could ever make investing in other stocks. It can’t pay out earnings to you while it’s still in its growth phase. But, what it keeps it does a better job growing than you could do on your own.
The second worst business in the world would be something that has high or even infinite returns on net tangible assets but can’t grow at all. This business can only pay out its earnings yield to you (so, you can only make 6% to 7% buying at a P/E of 15, 10% buying at a P/E of 10 and so on). The good news is that while this business can’t grow what it pays out to you, it will never need more money from you. What it earns, gets paid out to you – it doesn’t get retained.
The worst business in the world is something that grows while earning a low return on net tangible assets. This business is incapable of paying anything out to you. And the only way it can even return 7% a year or better if you buy it at a P/E of 15, is if it manages to grow fast enough ON A PER SHARE BASIS – after issuing the stock it needs and taking on the debt it needs to grow.
I would recommend avoiding all businesses that sometimes earn 15% a year or worse on their net tangible assets.
I would recommend focusing your search for businesses on those that almost always earn 30% a year or more on their net tangible assets.
If you do that, any growth you do get will be very valuable growth. At rates between 15% and 30% pre-tax it gets a little tricky. Businesses that grow faster even at slightly lower returns might be better. However, businesses with high consistency (very, very few years of sub 15% pre-tax returns on net tangible assets) may work out better than companies that are growing faster right now but generate unacceptable returns at the bottom of each cycle.
What you’re looking for is a business where you are confident that:
* There will be growth
* And that growth will be very profitable
And what you really want is for those two facts to hold true in almost every year you hold the stock.
I’ll let Warren Buffett sum up:
“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.”
That isn’t necessarily going to be the business with the highest returns on net tangible assets. But, it’ll never be a business with average or below average returns on net tangible assets. So, you always want to start by demanding above average returns on unleveraged assets. Once you know you have that, you can start worrying about growth.