Warren Buffett has mentioned that the economic case to justify the equity investments is that additional earnings above interest on fixed income securities (passive investments) would be derived via employment of managerial and entrepreneur skills in conjunction with that equity capital. People often think since an equity capital position is going along with greater risks than passive investing, it is entitled to a higher return. A “value-added” bonus from equity capital seems natural and certain.
He has pointed out that the business which has one dollar reinvested in the business would be expected to be valued at more than one hundred cents in the market (meaning the return on equity is 10%),and is already considered as “good business.” Comparing that with long-term taxable bonds yielding 5% and tax-exempt bonds of 3%, the business earning 10% on equity worth some premium to investors over the equity capital employed (taking into account dividend tax and capital gain tax, the individual investor might still realize 6-8%).
In the past, American business earned an average of 11% on equity capital employed and stocks, in aggregate, valued at the market far above that equity capital at 150 cents on a dollar. Buffett noted further in the letter to shareholders in 1981: “That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to think their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slow response time. But when change is great, yesterday’s assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.”
In the environment in 1981, at long-term taxable bond yields more than 16% and long-term tax exempts of 14%, and with American corporations earning 14% on equity, an American business was no longer worth one hundred cents on a dollar. Moreover, if we assumed the investor is in a 50% tax bracket, and the corporation pays out all earnings in dividends, the equity investor would realize only 7% tax-exempt bond equivalent. It was worth only 50 cents on the dollar for that investor.
On the other hand, if all earnings were to be retained and the return on equity was constant, earnings would grow at 14% per year. If the P/E stayed constant as well, so the stock price would grow at the same rate. But all of 14% can’t go directly into the investor’s pocket. After paying tax, the net return to investor might be even poorer than the passive after-tax rate. Companies earning 14% per year but paying no cash in dividends were the economic failure for the individual shareholders.
Moreover, in the inflationary environment, the low-return business normally must retain all of its earnings even though those are not good for shareholders as they have been proven to not use the cash very wisely.
“What makes sense for the bondholder makes sense for the shareholder. Logically, a company with historic and prospective high return on equity should retain much of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low return on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas… When the prices continuously rise, the 'bad' business must retain every nickel that it can…Inflation act as a gigantic corporate tapeworm. That tapeworm pre-emptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.”
Other discussion by Warren Buffett:
Warren Buffett: Non-controlled earnings and acquisition
Warren Buffett: Accounting And Bond Investment Of Insurers
He has pointed out that the business which has one dollar reinvested in the business would be expected to be valued at more than one hundred cents in the market (meaning the return on equity is 10%),and is already considered as “good business.” Comparing that with long-term taxable bonds yielding 5% and tax-exempt bonds of 3%, the business earning 10% on equity worth some premium to investors over the equity capital employed (taking into account dividend tax and capital gain tax, the individual investor might still realize 6-8%).
In the past, American business earned an average of 11% on equity capital employed and stocks, in aggregate, valued at the market far above that equity capital at 150 cents on a dollar. Buffett noted further in the letter to shareholders in 1981: “That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to think their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slow response time. But when change is great, yesterday’s assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.”
In the environment in 1981, at long-term taxable bond yields more than 16% and long-term tax exempts of 14%, and with American corporations earning 14% on equity, an American business was no longer worth one hundred cents on a dollar. Moreover, if we assumed the investor is in a 50% tax bracket, and the corporation pays out all earnings in dividends, the equity investor would realize only 7% tax-exempt bond equivalent. It was worth only 50 cents on the dollar for that investor.
On the other hand, if all earnings were to be retained and the return on equity was constant, earnings would grow at 14% per year. If the P/E stayed constant as well, so the stock price would grow at the same rate. But all of 14% can’t go directly into the investor’s pocket. After paying tax, the net return to investor might be even poorer than the passive after-tax rate. Companies earning 14% per year but paying no cash in dividends were the economic failure for the individual shareholders.
Moreover, in the inflationary environment, the low-return business normally must retain all of its earnings even though those are not good for shareholders as they have been proven to not use the cash very wisely.
“What makes sense for the bondholder makes sense for the shareholder. Logically, a company with historic and prospective high return on equity should retain much of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low return on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas… When the prices continuously rise, the 'bad' business must retain every nickel that it can…Inflation act as a gigantic corporate tapeworm. That tapeworm pre-emptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.”
Other discussion by Warren Buffett:
Warren Buffett: Non-controlled earnings and acquisition
Warren Buffett: Accounting And Bond Investment Of Insurers
