Buffet's Thoughts on Cost of Capital and the $1 Test
Buffet's Thoughts on Cost of Capital and the $1 Test
This post will touch on Buffett’s $1 test, which is how he thought about a company’s cost of capital.
5 minutes
What does the cost of capital mean?
The cost of capital is a very simple concept, but it’s also one that becomes very confusing if you read most textbooks on corporate finance.
The calculation of the weighted average cost of capital (WACC) is an example of how corporate finance has developed this concept. Where a theoretical cost of equity is used together with the cost of debt of a company.
In his 1984 letter to shareholders, Buffett addresses the relationship between the return on invested capital and the cost of capital through what he has called the $1 test.
“Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably 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 produces incremental earnings equal to, or above, those generally available to investors.”
So what is Buffett saying here?
Three things.
Value creation comes from the returns that a company can generate on reinvested earnings (incremental returns on capital), not just the returns they generate on previously invested capital (ROIC).
A company can have a high ROIC but not create additional value because they are unable to incrementally reinvest earnings.
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.
Effectively, the concept of cost of capital for Buffett is “what shareholders could earn elsewhere”.
Simple $1 Test
Assume an average stock market valuation of 10 P/E, or in other words, a 10% earnings yield.
Say a company valued by the market at $100 million earns a profit of $10 million and retains all of those earnings. The company will increase in value by $10 million if it can earn a return on that $10 million of 10%–what shareholders could earn elsewhere.
If the company can earn a 10% return on that retained $10 million, then its earnings will rise to $11 million the following year, and assuming the same valuation of 10 P/E, the business would now be valued at $110 million, thus passing Buffett’s $1 test. The $10 million of retained earnings created an additional market value of $10 million.
This isn’t a great return, as Buffett would be looking for retained earnings to create more value than just matching the cost of capital, but this is the minimum requirement that the company must meet in his mind.
Summary
Buffett uses a common sense approach to thinking about the cost of capital.
It all narrows down to:
“Will $1 invested by the company be worth at least $1 or more in the future?”
OR
“Will $1 invested by the company be more valuable than $1 invested by shareholders?”