Warren Buffett was once asked what his ideal business was by a shareholder at the annual Berkshire Hathaway (NYSE: BRK.A, BRK.B) annual general meeting. He answered:
The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.
Though he also said that businesses like that are very few, it's still an investing ideal to strive for. Many times investors look at earnings per share and profit margins, yet the sign of good management is how much of a return it can make from the debt and equity used.
For example, supermarket and general retailing giant Woolworths Limited (ASX: WOW) usually only has profit margins of around 4%, but its return on capital (debt and equity) is about 20%. It puts the capital to work and keeps on growing year after year.
Here are two companies that have a consistently high return on capital and good earnings growth that might please the multi-billionaire himself.
— Flight Centre Travel Group Ltd (ASX: FLT)
The well known travel and holiday reservations agency has been putting money back into the business to grow the store franchise both in Australia and abroad recently with good results. In a preliminary full year update, it stated seven out of ten of its business regions were expected to have record profits. It doesn't have a lot of long-term debt because regular revenues are enough to drive growth
Annual return on capital is regularly around 25% and earnings are forecast by analyst consensus to grow around a compound 9.5% annually for the next several years. Flight Centre is a perennial grower, more than doubling in share price in the past two years. It still has a strong brand name and good growth potential- two things I look for in a company.
— Carsales.Com Ltd (ASX: CRZ)
Earnings growth has been steady for the number one car sales search website. Above that is the return of capital that is regularly over 50% annually. It has to develop software and internet systems for its business, but as a website it doesn't have to build new factories or replace old machinery like a traditional company would. The amount of capital required is not as high, so every dollar of profit gives it a higher return on capital.
Also, its business has grown this far without having any long-term debt since 2010. Less debt also means a higher return on capital for each profit dollar. Buffett doesn't like businesses that need great amounts of capital to replace obsolete equipment or big capital expenditures just to stay competitive. Carsales.Com could be a stock he'd like if he wasn't so averse to computer-related businesses. I know I like it because it is expanding into growing Asian economies which will develop bigger and bigger car markets.
