Return On Capital – Different ROC For Different Business Segments

Previously, we discussed that, even if a company has a high existing overall return on capital (ROC), that might not necessarily indicate that the future ROC that the company can achieve on its new capital deployed would also be high. That’s why we discussed the concept of return on capital (ROC), versus return on incremental capital or return on new capital (RONC).

Now, let’s hear what Warren Buffett has to say about this topic, on return on incremental capital, in his 1984 Berkshire Hathaway shareholder letter (per below, emphasis ours).

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Warren Buffett on return on incremental capital

“In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. 

During an inflationary period, companies with a core business characterised by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return (as was discussed in last year’s [1983’s] section on Goodwill). But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. 

If a company sinks most of this money in other businesses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. 

The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional.

Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvellous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics).

The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)

In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock [at the right price] (an action that increases the owners’ interest in the exceptional business while sparing them participation in subpar businesses). 

Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.”

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Different ROC for different business segments

So, you have just heard it from Warren Buffett.

He highlighted the fact that, even if a company has high ROC, or high RONC, it might not mean that the management’s capital allocation is good, because different business segments or areas within the same company can have very different ROCs.

Which is why, for us investors, beyond analysing a company’s ROC and RONC, it’s also important for us to evaluate the ROC of different business segments within a company (where practically possible).

So, let’s talk about that today, using Amazon as an example.

The chart below show’s Amazon’s various ROC metrics over time – return on assets (ROA), return on equity (ROE), return on capital employed (ROCE), and return on new capital employed (RONCE). What do you think of them?

You might probably be thinking that they look bad, or at least, not good. Most of the ROC metrics were below 15% for many years, and the RONCE also fluctuated a lot and was mainly lower than 15%.

So, is it the case that Amazon has been reinvesting capital into areas with low returns, and that the management’s capital allocation is not good? Can we as investors do some more analysis to get us closer to the truth?

As some of you would have already known, over the years, Amazon has barely returned any capital back to the shareholders, and has been reinvesting heavily, on its capital expenditure, for organic growth.

As seen in the chart below, from 2011 to 2022: 

• Amazon has been reinvesting more than half of its operating cash flows (OCF) (before deducting the non-cash share based compensation (SBC) expenses) on capex (including lease payments).

• The capex reinvestment (as a % of OCF) averaged at a high 89% for the period 2008-2022, and shot up to around 140% in 2021 and 2022.

During an earnings call in 2021, the management shared that most (around 40%) of the capex was for the infrastructure to support the growth of Amazon Web Services (AWS), with the rest mainly for the fulfilment and transportation networks to support the e-commerce business.

So, is it possible for us investors to find out the ROC of the capital deployed to AWS, which is the business segment that Amazon has been throwing lots of capital after?

Unfortunately, life is not always perfect, and Amazon does not disclose all the financial data for its different business segments, sufficient for us to calculate the ROE or ROCE of the different business segments.

However, there is actually enough data for us to calculate the rough ROA for the different business segments.

As seen in the screenshots below (of Amazon’s 2022 annual report), Amazon discloses the breakdown of its operating income, and total assets, by its three business segments.

Thus, we actually have some data to calculate the rough ROA, but pre-interest and pre-tax (since we only have the segmental operating income data (not the net profit after tax data)) for the different business segments. For example, the 2022 ROA for AWS can be roughly calculated as dividing $23b by $88b, so 26%.

Conclusion

After going through Amazon’s case study, do you see how investors can better analyse the capital allocation skills of a management team?

We cover this concept in further details inside our Principles of Compounding with Bonds & Stocks program here (to be released soon). This article also concludes our four-part series on the topic of Return on Capital, so stay tuned for our upcoming articles that will explore something new!