Exploring ROA in SMB Acquisitions
The Strategic Framework Behind Dan Tagliatela’s Business Acquisitions
In an interview on Acquiring Minds, Dan Tagliatela mentioned using return on assets (ROA) to assess any business he might acquire. Through this lens, Dan wound up purchasing a 50-year-old asphalt sealing business in Connecticut. Of course, there was much more to Dan’s criteria for a good business than just ROA – but it’s a good start when you begin analyzing a company for acquisition. He uses both a quantitative (ROA) and a qualitative framework based on his time as a public equity analyst for an insurance company. Dan’s ROA approach and his background in public equity really struck a chord. It reminded me of Charlie Munger’s favorite metric, return on invested capital (ROIC).
Both ROA and ROIC are intended to evaluate the efficiency and profitability of a company, but they differ in what they measure and how they're calculated.
ROA measures how effectively a company is using its assets to generate profit, and is calculated by dividing the company's net income by its total assets. The result indicates how much profit a company generates for each dollar of assets it owns.
On the other hand, ROIC measures how effectively a company is using its debt and equity capital to generate profits, taking into account the capital invested by debt holders and shareholders. You calculate ROIC by dividing the company’s after-tax operating profit by invested capital (debt plus equity).
“Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return -- even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with one hell of a result.” ~ Charlie Munger
Following from Dan’s playbook, ROA is the metric you’d most want to use when evaluating an acquisition. ROIC would be a good metric to track post-acquisition.
Dan’s Framework:
Quantitative Criteria:
Return on Assets (ROA): This measures how effectively a company uses its assets to generate profit. Dan looks for companies that have a high return on assets. A high ROA indicates that the company is using its assets efficiently to generate earnings.
Asset Efficiency: Dan evaluates how much money needs to be invested in a business to keep it running, including property, plant, and equipment (CAPEX), receivables (money owed by customers), and inventory. He prefers businesses that require lower initial investment but still yield high returns.
Qualitative Criteria:
Industry Comparisons: Dan compares companies within the same industry to understand why some have higher ROAs than others. He looks for disparities in earnings relative to assets and tries to understand the reasons behind them.
Business Model Evaluation: He assesses whether a company's business model allows for sustainable high returns on assets. This involves understanding the dynamics of the company's market, its competitive advantage, and the stability of its returns.
Future Sustainability: Dan evaluates whether the high returns are sustainable in the long term, considering the company’s competitive advantages and industry dynamics. And geographic density and route-optimization seem to be key themes with both businesses Dan purchased.
Risk Assessment: He considers the risks associated with the business and whether the high return compensates adequately for these risks.
Dan uses this framework to identify businesses that are not only profitable, but also have sustainable and efficient operations. He also notes it’s important to understand why a company is generating a high ROA, and whether these returns are likely to continue in the future.
