Management acts as the steward of the corporation’s cash and their actions either result in an increase or decrease in shareholder value. Overtime investors and individuals in academia have come up with numerous concepts and formulas, which are commonly complicated and tedious, to assess whether management is effectively allocating capital. Warren Buffett, a man I’m sure needs no introduction, introduced a straightforward way of assessing managements capital allocation decisions.
“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.” – Berkshire Hathaway 1983 Shareholder Letter
This simply means that every $1 of earnings retained should translate to at least $1 in market value over time. If a corporation cannot achieve this, they should simply return cash to shareholders. Yes, as simple as that. Buffett uses a 5-year rolling basis when using this concept as he views the market as accurate judge of intrinsic value over long periods of time. As Ben Graham noted; “In the short run, the market is a voting machine but in the long run it is a weighing machine.
In 1984, Warren Buffett further alludes to this $1 test:
Unrestricted earnings should be retained only when there is a reasonable prospect- backed preferable by historical evidence or, when appropriate, by a thoughtful analysis of the future- that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produced incremental earnings equal to, or above, those generally available to investors
I have come across no better explanation and distillation of this passage than that written by John Huber of Saber Capital Management. He pointed out three things from this extract by Warren Buffett:
Value creation comes from the returns that the company can generate on reinvested cash (incremental returns on capital), not just the returns they generate on previously invested capital (ROIC)
Companies should only retain earnings if a dollar in the company’s hands is more valuable than a dollar in the shareholder’s hands.
The only way a company achieves #2 is to earn a higher return on that dollar than shareholders could earn elsewhere (which is another way of saying companies must produce returns on capital that exceed their cost of capital)
Now let’s see which companies pass this test. We need two values for this:
1. Retained earnings
-found in the balance sheet
2. Market Capitalization
Let’s see if Costco passes Warren Buffett’s $1 test
So over 5 years:
-Costco’s Market Value increase by $112 880 000 000
-Costco retained earnings totaled $58 275 000 000
Thus, during this period, $1,93 of market value was created for every $1 that Costco retained, thus Costco passes Warren Buffett’s $1 test.
This test serves as a valuable reminder that prudent investors should consider businesses that not only offer potential returns but also demonstrate the ability to allocate capital wisely. It encourages a disciplined approach to investing and serves as a litmus test for identifying companies with sustainable competitive advantages and sound financial management.
I am not sure about the logic set out here.
Yes, Costco's market cap increased $112bn, but how much would its market cap have increased if Costco had retained no earnings and instead paid them out in dividends? If the answer is more than zero then there needs to be an adjustment to arrive at return on incremental capital.
Second, market cap is a product of market sentiment (Ben Graham: Mr Market). Markets are not efficient. Price dislocation occurs all the time. Market cap is volatile and differs from intrinsic value. Think about how volatile the Tesla market cap has been over the past couple of years. Your methodology would provide an entirely different result from one week to the next. That is no use to management in making capital allocation decisions.
Third, Buffett doesn't care about market price. He never has. He focuses on intrinsic value. He wants to know that $1 retained will result in more than $1 of intrinsic value for the business. Your formula doesn't do that.
No, it is far more nuanced. What Buffett is saying in this 1983 and 1984 quote is that incremental returns (owner earnings - see the 1986 letter) must be greater than the sum retained after having accounted for risk free rates available elsewhere. So if the RFR is 5%, there is no sense in the business retaining $1 if it generates less than 5% above its cost of capital.
Hi
thanks for writing up this nice quick-hand test.
A question on your Costco example: I see you are adding the retained earnings entries. However, my understanding is that retained earnings are accumulated entries, i.e. the difference between any two entries is what was retained over that period of time, see e.g. https://www.investopedia.com/terms/r/retainedearnings.asp
If I am right, Costco only retained ca 8 billion USD, not 60 billion USD (which makes the 1$ test analysis even more impressive).
Kind regards