Buffett realized that in determining whether earnings of subsidiaries should be retained or paid out to the parents, the managers would have no trouble thinking as the intelligent owners. But the decision becomes difficult when it comes to parent company paying dividends to its shareholders. For example, the CEO of multi-divisional company would tell company A, with earnings on incremental capital expected to be 5%, to distribute to all of its earnings to the parent, as subsidiary B can have a higher rate of 15%. In addition, that CEO would need a full explanation from any subsidiaries for the reason for retaining all or a large part of their earnings rather than pay the parent. But the CEO hardly provides the shareholders of the parent company with the similar full reasons and the analysis.
Within the corporation with multiple divisions, during inflation time, companies with great economic characteristics can use small amounts of incremental capital at high rates of return (check out discussion of Warren Buffett on great business from economic goodwill). But unless they are having very high unit growth, outstanding businesses would generate a lot of excess cash. However, if the excess cash created by good quality subsidiaries is being used to pump into other businesses earning low returns, the company’s overall return on retained capital still appears very good because of the core good business return. It’s the same for the Pro-Am golf event: “Even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional.” That is why Buffett advised the shareholders to not simply compare total incremental earnings with total incremental capital because that doesn’t reveal or even distort what is really happening in its core business.
Actually investors should be careful even when corporations consistently show good returns on both equity and on overall incremental as many of them have employed a large portion of their retained earnings on economically unattractive businesses. And corporations and CEOs nowadays often engaged in high-priced acquisitions of the businesses with mediocre economic characteristics. Shareholders would be far better off if earnings were retained only to expand the core great businesses, with the rest paid in dividends or used to buy back their own stocks.
Buffett has noted further that the managers using excess cash from high-return businesses to invest into other low-return businesses should be responsible for low-quality capital allocation decisions, regardless how profitable the overall corporation is. And “if earnings have been unwisely retained, it is unlikely that managers, too, have been unwisely retained”.Also check out:
Within the corporation with multiple divisions, during inflation time, companies with great economic characteristics can use small amounts of incremental capital at high rates of return (check out discussion of Warren Buffett on great business from economic goodwill). But unless they are having very high unit growth, outstanding businesses would generate a lot of excess cash. However, if the excess cash created by good quality subsidiaries is being used to pump into other businesses earning low returns, the company’s overall return on retained capital still appears very good because of the core good business return. It’s the same for the Pro-Am golf event: “Even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional.” That is why Buffett advised the shareholders to not simply compare total incremental earnings with total incremental capital because that doesn’t reveal or even distort what is really happening in its core business.
Actually investors should be careful even when corporations consistently show good returns on both equity and on overall incremental as many of them have employed a large portion of their retained earnings on economically unattractive businesses. And corporations and CEOs nowadays often engaged in high-priced acquisitions of the businesses with mediocre economic characteristics. Shareholders would be far better off if earnings were retained only to expand the core great businesses, with the rest paid in dividends or used to buy back their own stocks.
Buffett has noted further that the managers using excess cash from high-return businesses to invest into other low-return businesses should be responsible for low-quality capital allocation decisions, regardless how profitable the overall corporation is. And “if earnings have been unwisely retained, it is unlikely that managers, too, have been unwisely retained”.Also check out:
