Charlie MungerWarren Buffett

Thoughts on Cost of Capital and Buffett’s $1 Test – Part 1

“I’ve never heard an intelligent discussion about ‘cost of capital’.” – Charlie Munger

I read something a few weeks back that referenced some comments that Charlie Munger once made on the topic of cost of capital. Maybe these comments will be yet another unintelligent discussion of cost of capital, but I thought I’d share some notes I wrote down this past week as I gave this concept some more thought. This post will touch on Buffett’s $1 test, which is how he thought about a company’s cost of capital, and then in the next post I’ll outline the cost of capital concept and how I like to think about it when thinking about investment ideas.

The cost of capital is a very simple concept, but it’s also one that for some reason becomes very confusing, theoretical, and abstract (especially if you consult most textbooks on corporate finance). The phrase “cost of capital” is often used in conjunction with “return on capital”, and both can be mired in either academic theory or the false sense of precision that comes from manipulating numbers in a spreadsheet.  

As usual, Buffett has some common sense things to say about the relationship between returns on capital and cost of capital, and sums it up best with what he has called the $1 test.

From Buffett’s 1984 shareholder letter:

“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:

  1. 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)
  2. Companies should only retain earnings if a dollar in the company’s hands is more valuable than a dollar in the shareholder’s hands.
  3. 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)

When Buffett talks about a dollar of retained capital creating a dollar of market value, he’s talking about the stock price over time (he said later in that 1984 letter that he’d evaluate this over a five year period). He’s talking about a dollar of intrinsic value, but he’s implying that the stock market will be a fairly accurate judge of intrinsic value over time. And he’s saying that the market over time will reward businesses that create high returns on the dollars they keep (by giving them a higher market value, i.e. stock price), and the market will punish (with a lower valuation) those companies whose dollars retained fail to earn their keep.

Simple Example $1 Test

To look at a very simplified example, let’s assume an average stock market valuation of 10 P/E, or in other words, a 10% earnings yield (which was roughly what stocks were valued at on average when Buffett wrote these words in the early 1980’s). If a company valued by the market at $100 million earns a profit of $10 million and retains all of those earnings, the company will only increase the value by $10 million if it can earn an incremental return on that $10 million that exceeds what shareholders could earn elsewhere. In this example, shareholders have plenty of other alternatives to earn a 10% return on their capital (since the market average in this case has a 10% yield). So 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 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 (note that if earnings were distributed, an individual would actually have to earn a higher return on those incremental earnings than what the company earns internally to account for capital gains taxes on the dividend, but this simple example illustrates what Buffett is trying to get across).

It’s worth noting that Buffett doesn’t use the phrase “cost of capital”, and he doesn’t think about the concept the way most people in finance think about it. Munger said they’ve never used that phrase in practice.

However, just like DCF’s (which is a tool Buffett is skeptical of in practice, despite agreeing with the general method in principle), Buffett and Munger essentially do the cost of capital calculation in their head. They implicitly use and understand both DCF’s and cost of capital calculations even if they don’t explicitly label them.

Return on Incremental Invested Capital

Value is created when companies earn returns on capital that exceed their cost of capital. In the next post, I’ll outline my own thoughts on how to think about cost of capital, and what that really means, but despite Buffett and Munger’s dislike for the term, they clearly understand and utilize the concept when they make investment decisions. But for now, I’ll review the other piece that Buffett is talking about, which is that the growth of a company’s intrinsic value depends on the returns it can earn on its incremental capital investments.

When I analyze companies, I always try to figure out what I think their returns on incremental capital will be going forward, as that is a key variable in determining the rate at which the company’s intrinsic value will compound at over time. I’ve written about the importance of ROIC in the past, in a series of posts (read them here), but basically, a firm’s value will grow at the product of its returns on incremental capital times the amount of earnings it can reinvest (plus any added benefit to allocating the portion of capital that couldn’t be reinvested back into the business).

Saber Capital’s Basic Investment Objective

My investment firm’s strategy is centered around the idea that companies can be put in one of two main buckets:

  1. Those companies that will be more valuable in five years or so, and
  2. Those that will be worth less.

As the former Michigan football coach Bo Schembechler once said, each day you’re either getting better or you’re getting worse, but you’re not staying the same.

So given this simple idea about two main buckets of companies, I try to stay focused on the first bucket – those companies that will have a higher intrinsic value (the present value of the future cash flows will either be higher or lower in five years). As we know, stock prices can fluctuate wildly in the short-run, but over time they will converge with their intrinsic value. And if that value is marching upward over time, it becomes a tailwind for me rather than a headwind. Another way of saying this is that my margin of safety (any gap between my purchase price and intrinsic value) widens over time.

One way of filtering the universe to find “1st Bucket” companies is to figure out if the company is passing Buffett’s $1 test.

Google’s $1 Test

Alphabet (Google) is a obviously a great business, and so I glanced at the last five years of numbers to see how it fared in Buffett’s $1 test. Buffett said in that 1984 letter that because the market is obviously volatile, he preferred looking at a longer period of three to five years to be able to draw conclusions on whether that dollar of retained earnings actually created real value.

So here is a look at the overall value GOOG created from each $1 of retained earnings:

This is just a quick way to glance at the returns that Google is generating from its incremental capital. It doesn’t measure the returns on capital specifically and obviously leaves plenty to be analyzed, but it does show that Google has been very productive with the earnings it has kept (creating nearly $5 of market value for shareholders for each $1 it retained during this 5-year stretch).

Note that this doesn’t include 2017, which has seen tech stocks soar to new heights (Google is up over 30% YTD). Some have quibbled with Google’s approach to “other bets” (financed through the huge cash flow of its incredibly profitable core search business – Google spent over $1 of every $4 of revenue on R&D and capex last year and still made around $20 billion of free cash flow!).

We’ll see how/if/when the other bets pay off, but I think it’s reasonable to conclude that Google is creating plenty of value for shareholders by retaining earnings.

Incremental ROIC and Buffett’s $1 Test

The way Buffett measures whether a firm can create $1 of market value for each $1 of retained earnings is to measure whether the returns on those earnings exceed what shareholders can earn elsewhere (at a given level of risk). So what Buffett is talking about here is the return on incremental capital, or ROIIC, which is really the entire point of trying to analyze a firm’s ROIC.

I outline a back of the envelope way to estimate a firm’s ROIIC in this post, but basically, the point behind this concept is that we want to know what returns the company will generate on its investments going forward. We can look at the return on capital it previously invested (which is what ROIC measures) as a proxy or guide for what the company might earn going forward, but what matters to us as investors is what the company will do with its capital from this point forward. It really doesn’t matter that a firm has a 50% ROIC if there is nowhere to invest earnings at that rate going forward. That still might be a good business that throws off a lot of cash flow, but what we really want to know as potential owners is what the future returns on incremental investments will be, as that is what will determine how quickly the earning power of the business (and thus the intrinsic value) will compound.

In the simple example above of the company that retains and reinvests $10 million of earnings and has $100 million market value (P/E of 10), if the company only earned a 5% return on that retained capital, then that $10 million would only produce $500,000 of earnings growth, or 5%, which is unlikely to be better than alternative options for owners. You could take your piece of that $10 million and invest it elsewhere at a rate higher than 5%. Over time, the market would likely begin to devalue these retained earnings such that each incremental dollar the company reinvested (that only produces 5% in a world where 10% is attainable) would wind up getting valued at less than a dollar in the stock market.

On the other hand, if the company earned 20% returns on that retained capital, then earnings would grow by $2 million for a total of $12 million of earnings, and the value of the business would be $120 million at the same P/E of 10, meaning that $10 million of retained earnings created $20 million of additional market value. $2 of market value was created for each $1 retained in this case. 

Now, P/E ratios obviously don’t remain static. In reality, the business that earned just 5% in a world of 10% earnings yields would likely see the valuation decline, thus not only failing to produce adequate ROIC, but the market would also value the earnings at a lower multiple, thus clearly failing Buffett’s $1 test.

And the business that generates a 20% ROIC will likely see its $12 million earnings garner a higher P/E. At 12 P/E, the business is now worth $144 million, thus creating $4.40 of value for each $1 it retained, and thus clearly passing Buffett’s $1 test.

To Sum It Up

So like so many other lessons, Buffett uses a common sense approach to thinking about returns on capital and cost of capital. With the $1 test, he is clearly talking about cost of capital, and he clearly is judging company returns on capital relative to that cost of capital, but he is doing it in a much more common sense way that has more practical use than trying to figure out industry betas, equity risk premiums, WACC, etc…

The next post will have some more notes on how I like to think about cost of capital including the differences between what companies estimate their cost of capital to be going forward and what it actually turns out to be (the difference largely due to the inefficiencies of the stock market). I’ll also mention why measuring your opportunity costs is the most logical way to think about cost of capital, and I’ll have an example of how Buffett thinks about cost of capital using one of his investment mistakes.

Have a great week!


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at john@sabercapitalmgt.com. 

18 thoughts on “Thoughts on Cost of Capital and Buffett’s $1 Test – Part 1

  1. Hi John,

    Enjoyed the post and always find the ROIC discussion insightful as a long term estimate of underlying value. My question is whether when assessing the value created should we not be using some other criteria than market cap? E.g. a company like Tesla has had large market cap gains on no gain in retained earnings. Is it really a reflection of intrinsic value or just the market’s perception of intrinsic value?

  2. Hi John,
    Great article, I like to read your ROC/ROIC series, always keep it in my mind and practice when analyze any business.
    Waiting the part 2 of this post.

  3. Very illuminating article. While studying the financial statements to analyze a company, knowledge gathered studying your articles help a lot. I would be keenly waiting for the next post.

  4. Thank-you for sharing your interesting insights on the cost of capital. It’s not something I recall seeing discussed before and found it very helpful.

    But I am curious about the calculation comparing retained earnings to the growth in value of Google’s market value. It seems to me that the increase in the market value could just as likely be attributed to an increase in the PE ratio. The calculation seems more a market assessment than an actual assessment. The market might not be assessing growth but enthused about potential growth, that might be more about stories and fevers than anything actually happening.

    As you comment after the calculation, “It doesn’t measure the returns on capital specifically and obviously leaves plenty to be analyzed.”

    I was wondering if it wouldn’t be more useful to instead measure the increase in the book value of the company less the retained earnings, and to look at ROE or ROIC to see if the rate of return is rising, stable or falling? Although that leaves the calculation vulnerable to accounting issues such as intangibles.

    During the period being compared, the company might take on a lot more debt leveraging up its earnings and pushing up its market value, but not necessarily with a sustained rate of return on its capital.

    Perhaps you might see the market value growth if you applied the same PE ratio at the end as was used at the start?

    I wonder if looking at the ROIC and retained earnings, if the latter is growing and the return is stable or growing, I imagine that would indicate the company must actually be growing.

    As you’re planning to do more articles in this series I hope you might explain these concepts more fully. Thanks again for taking the time to write such helpful articles.

  5. Hi John,

    How do you reconcile this analysis against the Total Return framework (Return = Dividend Yield + Earnings Growth)? If I understood your article correctly, Buffett’s definition focuses on the growth component of the equation (in this case, growth in retained earnings). How would you extend this analysis to a company that pays out all its earnings in dividends?

  6. John,

    Should there be some adjustment of the increase in market value for additional capital raised–equity and/or debt. Maybe retained earnings per share compared to market value per share? Otherwise, a company could increase retained earnings by $500 million over five years, and if they raised $700 million of equity in the fifth year, the market value would have increased by more than the increase in retained earnings even if the stock price remained flat.
    Maybe this issue would be addressed by using increase in invested capital rather than simply increase in retained earnings?

    1. Yeah Tony, I think the concept is to focus on per share value, so you’d want to adjust for any new equity capital that the company issued. (And that new equity capital should also meet Buffett’s $1 test – i.e. it should also produce a return that would at least equal what investors who put up that capital could achieve elsewhere. If it doesn’t that equity capital will not result in market value in the end).

  7. I have incorporated the $1 calculation in all my investments the past 30 yrs, it is the most useful gauge of capital allocation success and management competance there is. Accumulated retained per share/ price appreciation how simple. Thanks this is the first time I have seen anyone write about it.

  8. Hi John, thanks for your article ! As always very instructive. Can’t wait for the second part.

    There’s something I’m confused about : does the fact that $1 of retained earnings generate at least $1 of market value necessarily induces that the return of the retained earnings is superior to the shareholders’ cost of capital ?

    From a capital allocation perspective, the way I understand it is that if the present value of the expected cash flow of the $1 of retained earnings is superior to $1, that means that the expected return of the investment (i.e., the $1 of retained earnings) is superior to the initial cost of the investment ($1), but not necessarily that the return of the investment is superior to the cost of capital of the shareholders.

    After reading your post, I googled for the $1 test and found that Buffett, after getting a question during the 2009 annual meeting, added a second layer to the test by comparing the book value gain of Berkshire Hathaway to the performance of the S&P 500 (http://www.berkshirehathaway.com/ownman.pdf). If I understand well, that offers a solution to the return of the retained earnings being superior to shareholders’ cost of capital by comparing the Berkshire’s book value growth (which Buffett considers to be “a conservative but reasonably adequate proxy for growth in intrinsic business value”) to the performance of the S&P 500 (which he considers to be the shareholders’ next best alternative).

    Does it make sense ?
    Thanks.

    1. Thanks for the comment. To answer your question, a dollar of market value in the near term (a year or two) doesn’t necessarily mean that the retained dollar created a dollar of value. What Buffett is trying to say is that each dollar of capital retained should create at least a dollar of value. The market value (stock price) is a proxy to determine the value over the long haul, but not necessarily in the short term. Buffett says the way that a dollar of retained earnings creates a dollar of value is if that dollar can earn a return that at least equals what investors could achieve elsewhere (let’s say this is 10%). In other words, if you invest in a small local business and that business earns $200,000. Should the business retain that $200k or pay it out to you (the owner). The way you would answer this question is to decide if the business could invest the $200k and earn a higher rate than you could earn elsewhere. If you could earn 10%, then the cost of capital (opportunity cost) is 10%. The retained earnings will create $200k of value if it can earn 10% or more. If not, then it would have been better off in your ends. If it earns 5%, then it earned less than what you could have earned elsewhere, and thus that 5% return carries an opportunity cost. The opportunity cost is what you could have earned.

      Basically, Buffett is saying that if a business doesn’t earn a return that investors could earn elsewhere, then that business will destroy value. Another way of saying this is that if the return on capital isn’t equal or better to the cost of capital (what investors could earn elsewhere) then the business will destroy value.

  9. Hi John,

    Thanks for the post, I’ve recently discovered your work and I am finding your writings very insightful.

    If you take a company that generated 10m in earnings this year (and retained all its earnings) and then went on to generate 12m in earnings the following year, I was just wondering how one would go about identifying the incremental return on retained earnings? To say that the 20% increase in earnings was only attributable to a 20% return on incremental capital on the 10m retained earnings means that we would be ignoring any other strategies or changes that management may have previously implemented that are only coming through now? Or perhaps a cycle company that went through an earnings slump this year and then went on to increase earnings by 50% the following year, you wouldn’t assume the company is now earning 50% on incremental capital invested. Curious as to how you take these factors or scenarios into account.

    Many thanks and I look forward to more articles.

    1. Hi Thomas. Yes, those are good questions. I think you’re right that since earnings can be volatile, you have to look at the ROIIC calculation over a period of longer than just one year. You really want to know what the company is earning on the capital it reinvests over a longer period of time (say, over a full business cycle).

  10. Good read, thanks for sharing. I agree that the current framework for evaluating cost of capital, particularly equity value, is utterly ridiculous. The impact that a small change in Beta (which in no way is related to risk, as Buffett repeatedly points out in his shareholder letters) can have on a DCF value is silly. Buffett does mention cost of capital a few times in his letters. Off the top of my head, if I am remembering correctly, he mentions it once when specifying the cost of a private plane for management ”as cost of capital plus depreciation” and again when walking through some math on the perpetuity formula: earnings/(r-g). He assumes cost of capital at 10% for most of the writings in his letters from what I have seen.

  11. I respectfully disagree with the argument that Google has created high incremental ROIC through its retained earnings. A fairly large portion of Google’s FCF remains on balance sheet as cash and other investments which represent low-yield investments (T-bills and the like) due to the tax costs of repatriating foreign cash.

    I actually would not think of Google as a reinvestment moat business in your categorization but rather a capital light compounder – had Google returned 100% of its FCF in the form of repurchases and dividends (and correspondingly removed it from retained earnings), I doubt it’s 20%+ top-line CAGR the past 5-10 years would have changed, similar because it is able to generate a very large amount of high margin revenue without any real additional reinvestment given the operating leverage in the business (it does not take much additional capital, if any, to serve ads, and the majority of the incremental capex has been focused on building the non-profitable parts of the business ala Fiber and Google Cloud Platform, both of which are more cap intensive than Adwords/Adsense, and to a smaller extent, Youtube). the tailwinds related to the transition from digital advertising, and Google’s historically mixed track record of R&D and investments.

  12. [Note this should replace the other version I typed]
    Thanks for this post John – this is a very helpful and illuminating lens on ROIC and compounding. Your framework for thinking through no-moat/high-moat/reinvestment moat/cap light businesses have been enormously helpful to my own investment process.

    One thing I respectfully disagree with in your write-up is the argument that Google has created high incremental ROIC for its shareholders through its retained earnings. Notwithstanding the argument that the market is not necessarily the best proxy for intrinsic value given the P/E ratio fluctuation over even a multi-year period, I think it is very difficult to make the argument that the retained earnings at Google actually generated ROIC in the first place.

    First, a fairly large portion of Google’s FCF remains on balance sheet as cash and other investments which represent low-yield investments (T-bills and the like) due to the tax costs of repatriating foreign cash. Second, I think of Google as not as a reinvestment moat business in your categorization but rather a capital light compounder – it simply does not really need to invest heavily to maintain growth and it would likely have seen a similar level of earnings growth without any retained earnings on the balance sheet. Had Google returned 100% of its FCF in the form of repurchases and dividends (and correspondingly removed it from retained earnings), I doubt it’s 20%+ top-line CAGR the past 5-10 years would have changed given that the growth has come from the addition of advertising dollars onto the platform at very high incremental flow-through margins (even if somewhat offset by the shift to mobile and the increase in distribution TAC and Adsense revenue sharing, but that is another story…) due to the secular tailwinds associated with the shift to digital and the self-reinforcing nature of search. Google does not require much additional capital, if any, to serve these incremental ads, and the majority of the incremental capex over the past few years has not been related to advertising but rather on building the non-profitable parts of the business – Fiber and Google Cloud Platform, both of which are more cap intensive businesses than Adwords/Adsense, and to a smaller extent, Youtube).

    As a result, for certain cap light companies, I would argue that it is meaningless to calculate an incremental ROIC on the business simply because the growth and the investments are not related. For example, if I have a money-printing machine that prints $1 million per year in 2017, and that machine will print 5% more dollars every single year without breaking or requiring maintenance, it does not matter if I keep 10%, 50%, or 100% of the profits inside the machine because the growth of the money printed per year will be the same no matter what. However, that cap. allocation decision would influence the ROIC of the business (as well as the ROIIC). In a way, this is a superior business to the reinvestment moat business because you will see earnings growth even with poor capital allocation by the management team the business can continue to compound nicely, and quality cap. allocation becomes a kicker on top.

    Would love to hear your thoughts on this – thanks!

    1. Thanks for the comment. I think you make good points on Google. I think you can make an argument that since the core business doesn’t require much capital (and likely only a tiny fraction of the whopping $25 billion of R&D and Capex that Google spent last year) that most of the retained earnings are going toward other projects (or just sitting in cash). In general, it was an example I thought I’d use just to illustrate the math of Buffett’s test. However, I’m not necessarily convinced Google isn’t creating a lot of value with those retained earnings. I’m certain their intrinsic value has increased significantly over the past five years (and obviously so has the stock price), and I’m not sure how much Google needs to spend to maintain and grow their search business. The other bets haven’t paid off yet, but haven’t cost the company much in relative terms. A big portion of those earnings, as you say, have just piled up. Maybe time will tell whether they’ve created value.

      On the other side of the coin, I think it’s hard to argue with the results of the overall business (in terms of the value it has created from the capital it has employed overall), and it’s not certain to me that some of those investments haven’t benefited the search business. Maybe capital spent in the healthcare business or in the Waymo division taught them something that helped improve their core franchise. Seems like completely unrelated business lines, but sometimes experience and learnings in one area accrue to the overall company.

      But in general, I agree with your point about Google’s search franchise being a capital light business that doesn’t really to retain any earnings. Maybe the book isn’t yet written on the value that today’s retained earnings will create. We’ll have to see if any of these moonshots pay off at some point.

      Thanks for the comment, and thanks for reading!

Leave a Reply

Your email address will not be published. Required fields are marked *