Many retail investors love to learn from Warren Buffet's investing lessons especially those under the classification of Value Investors.
"Your success in long-term investing may not be what you actually see and get now. Your delay Gratification may lead to super return that you couldn't even believe it." - Createwealth8888
Warren Buffett and the Magic of Retained Earnings
Let Me Have A Dollar
If I had a magical process for investing capital at a high
rate of return, let’s say at 20 percent, and you invest $5 with me, at the end
of the year I will have made you $1.
You will now be faced with three options:
1. You can take the $1, in which case you can spend it or invest it elsewhere, perhaps in a llama farm.
2. You can leave the $1 with me and allow me to reinvest it for you.
3. Or together, we can use the $1 to buy out existing shareholders.
The first question that should come to mind, if you leave the money with me to reinvest, is “are our children learning,” and next, “Will I have the ability to continue generating the 20 percent rate of return?” Then, if you take the $1, what rate of return can you expect to achieve … in the llama farm? The answer to the first question is found in two components:
1. The track record of ROE in my business.
2. The historic retained earnings off of my business’s balance sheet.
If historically, my business has retained earnings and the ROE has remained strong, averaging 20 percent, then by all appearances the business has the ability to put the $1 to good use, reinvesting it at the high rates of return on equity. If, on the other hand, my business has historically retained earnings (plowed them back into the business for expansion, new business projects, and so on), yet the return on equity has steadily dropped over the years, then it appears that I have poorly allocated retained earnings into low returning investments, and I do not have the capability to effectively expand the business or, at the very least, the core, original business has begun to suck wind. Either way, you will see this as a drop in ROE and perhaps a paltry, anemic ROE track record.
You will now be faced with three options:
1. You can take the $1, in which case you can spend it or invest it elsewhere, perhaps in a llama farm.
2. You can leave the $1 with me and allow me to reinvest it for you.
3. Or together, we can use the $1 to buy out existing shareholders.
The first question that should come to mind, if you leave the money with me to reinvest, is “are our children learning,” and next, “Will I have the ability to continue generating the 20 percent rate of return?” Then, if you take the $1, what rate of return can you expect to achieve … in the llama farm? The answer to the first question is found in two components:
1. The track record of ROE in my business.
2. The historic retained earnings off of my business’s balance sheet.
If historically, my business has retained earnings and the ROE has remained strong, averaging 20 percent, then by all appearances the business has the ability to put the $1 to good use, reinvesting it at the high rates of return on equity. If, on the other hand, my business has historically retained earnings (plowed them back into the business for expansion, new business projects, and so on), yet the return on equity has steadily dropped over the years, then it appears that I have poorly allocated retained earnings into low returning investments, and I do not have the capability to effectively expand the business or, at the very least, the core, original business has begun to suck wind. Either way, you will see this as a drop in ROE and perhaps a paltry, anemic ROE track record.
Posts
relatively, a small or medium business has much higher chance to obtain high ROE. When it grows larger, it is becoming more and more difficult to achieve high ROE. One of the reason, mature companies start to pay high percentage of profit as dividends against retained for future growth. More often, even if the owner knows the company will not grow that fast, it continue to invest retained earnings for a much smaller return. sad story for minority shareholders.
ReplyDelete