Warren Buffett believes that earnings growth is overrated and he's even said it's an improper figure on which to focus but why aren't all CEOs trying to grow their company's earnings well Buffett explained his reasoning in his now famous 1979 letter to shareholders in this video I'll break down why Buffett believes that earnings growth is overrated and what metric he looks at to judge a CEO's performance instead hi my name is Brian Feroldi I'm a financial educator who's been analyzing and investing in businesses for more than 20 years now in 1979 Warren Buffett successfully grew Burk
shar's earnings by more than $3 million or nearly 9% but he quickly downplayed this achievement now Buffett noted in that same letter that he had substantially more Capital to work with in 1979 than in 1978 and he even took a dig at himself saying that our performance in utilizing that Capital fell short of the earlier year even though per share earnings Rose this is why Buffett wasn't impressed with his own performance and growing earnings he knew that had more Capital work with in 1979 so he would expect that his earnings per share would grow due
to that fact alone Buffett then went so far as to say that earnings per share would rise even in a dormant savings account simply because earnings are continuously plowed back and added to the capital base this is why Buffett says that earnings and earnings per share are so overrated simply because they ignore the underlying Capital base that the management teams are working with so if Buffett doesn't think that looking at earnings growth is the best way to to judge his performance what is well in that same letter to shareholders he later said that the primary
test of managerial economic performance is the achievement of high earnings rate of equity Capital employed and not the achievement of consistent gains in earnings per share well that begs the question what does return on Capital employed even mean well to understand that let's first think of how a regular savings account Works money gets put into the account from a person's savings at aank bank and then the bank pays that same account holder in the form of Interest so for example if you put $1,000 into a savings account and the bank was paying 5% interest you
would earn $50 in interest payments per year now here's a question for you if we wanted the interest rate on that tank account to increase what could we do well one extremely simple answer is to put more money into the savings account if we increase the amount of money we put into the savings account say doubling it to $2,000 and and that interest rate of 5% stays the same well we would double the interest that we were getting paid every year in this case it would go up to $100 now there's nothing magic going on
here when you put more money into a savings account you naturally expect more interest will be paid to you well believe it or not but this exact same simple logic also applies to businesses in fact it could be helpful to think of a business the same way that you think of a bank account money goes into the business from investors in the form of equity and from lenders in the form of debt the company then puts that money to work to generate more money now there are lots of ways to measure how much money is
coming out of a business such as net income which is also called earnings and earnings per share now that we know this here's a question for you if we wanted to increase the earnings per share of a company how would we do that well one simple way is to put more Capital into the business if the company generated the exact same return on the money that was put in you would now expect more earnings to come out this is exactly why Buffett wasn't impressed with his 1979 performance more Capital was put into birkshire Hathaway so
naturally he would expect that more earnings would come out of birkshire Hathaway This is why he believes that focusing on earnings and earnings per share alone is so overrated it ignores how much Capital went into the business in the first place to generate that earnings so instead of looking at earnings and isolation what matters to Buffett is the ratio between how much money went into the business to how much money comes out of the business if you can measure those two things it will tell you the interest rate that the business is generating on the
capital that goes into it so how do we figure out what the interest rate is that a company is earning on the capital well this is what return on Capital ratios measure they tell you the interest rate that a company is earning by comparing how much Capital goes into a business to how much Capital comes out of a business now there are many return on Capital formulas but they all follow this basic structure in the numerator is what the business earns on an annual basis and in the denominator is how much Capital was invested in
the business now how do we measure what a company earns on an annual basis this is how much profit comes out of the business and there are numerous ways to measure profit we already talked about net income and earnings per share but you can also use metrics like net operating profit after tax or noat as well as ebit or earnings before interest in taxes now where do we go to find these metrics well the answer is almost always on the income statement so that's why when measuring Returns on Capital the numerator is always a profit
metric from the income statement now how do we figure out how much money was invested in the business well the way that we can tell how much money went into a business is by looking at the amount of equity that investors put in and the amount of debt that lenders put in now where can we find these numbers well debt and Equity is always listed on a company's balance sheet the debt is always found in the liabilities section and the equity is always found in the shareholders Equity section now there are lots of formulas for
measuring the return on Capital that business generates depending on what you put in the numerator and the denominator but Buffett tends to focus on three primary calculations so metric that he looks at number one is called return on Equity the formula here is very simple it is net income in the numerator and average total equity in the denominator so when we think about this equation visually in the numerator is the amount of net income that a business generates as found on the income statement and in the denominator is how much Equity was put into the
business which we can find by looking at the shareholders Equity portion of the balance sheet now return on Capital metric number two is something called return on Capital employed or R oce the formula for this has earnings before interest and taxes in the numerator and assets minus current liabilities in the denominator so when thinking about this calculation visually we take the company's operating income in the numerator or earnings before interest in taxes and then we divide by the company's assets minus its current liabilities the difference between those two will tell you how much Capital has
been employed in the business the final return on Capital metric to look at is something called return on invested capital or roic formula for this is net operating profit after tax in the numerator and invested capital in the denominator so when thinking about these numbers visually we take the company's operating income or net operating profit and then we subtract out the tax expense that the company has and then we divide that by the company's assets minus its accounts payables and acred expenses and any excess cash that the company carries now there's no need to calculate
any of these return ratios yourself we can use software like finat to this automatically so in finat you simply click on financials and then ratios and then scroll down to Capital efficiency when we open this up we can see that we have return on invested Capital return on equity and return on Capital employed right here if we click on return on invested Capital we can actually see it being graphed over time now great we know the math Behind these calculations but how do we interpret the results well the truth is that the results can vary
greatly depending on the industry that the company is but there are some general guidelines that I think are helpful to think of when looking at the results of any of these calculations I consider a low number to be anything less than 10% I consider an average number to be between 10% and 15% and I consider a high number to be anything that's consistently over 15% if you can find a company that consistently generates Returns on Capital over 15% that's kind of like finding a savings account that pays a 15% interest rate now that we know
what these numbers mean let's compare and contrast a few different companies using finat so we can tell how much return they're getting on their invested Capital to start with let's pull up a simple company like Chipotle which is ticker symbol CMG using finat I had this calculate Chipotle's return on invested Capital over over the last decade we can see that in 2015 the Cy generator turns on capital of 20 26% that number dipped in 2016 to just 2% but it's been climbing back ever since it did dip again in 2020 due to the pandemic but
it's been rising for a couple years and recently clocked in at about 19% so Chipotle is currently earning a 19% return on the capital that's been invested in the business now let's compare that to a company like Boeing which has been struggling recently back in 2015 the company was earning return Returns on Capital that were just shy of 10% reaching a climax of about 133% in 2018 after that the company ran into a series of issues that has caused its return on Capital to struggle mly more recently the company has even struggled to earn a
positive return on Capital so when we compare the returns that chipotle and Boeing are earning on invested Capital it's not surprising to me at all that Chipotle stock has been soaring over the last decade and Boeing stock has been struggling now if you're like me you might be thinking why don't I just B buy the highest return on investment companies that I could find well that's certainly a good starting point but just remember that Buffett called this the primary test of manage performance not the only test moreover there's more to finding a good investment than
just finding a company that generates High return on invested Capital there are plenty of other factors to consider as well such as the company's moat reinvestment opportunities Capital allocation decisions management team valuation risks and More in fact if you look at Warren Buffett's own investing checklist it's obvious that having high Returns on capital is very important but it's only a tiny piece of the overall pie that he uses to make investment decisions now speaking of Buffett's investing checklist if you want a free PDF copy of that graphic I just showed you on the screen simply
visit longtermmindset.co/BuffettChecklist or click the link in the video description and I'll email you a free copy well thanks so much for watching this video I hope it helped to cleared up why Buffett thinks so highly of Returns on Capital and not just earnings per share if you enjoyed it the thumbs up really helps us out on YouTube and let me know in the comments section below what other topics you'd like me to tackle now if you want to continue learning from here I highly recommend that you watch this video next
