Building a Small Business that Warren Buffett Would Love by Unknown

Author:Unknown
Language: eng
Format: epub

For our current location on the road map, see Figure 4.3 .

Figure 4.3 Building a Small Business Warren Buffett Would Love the Flowchart

Notes

1. Mary Buffett and David Clark, Buffettology (New York: Fireside, 1999), 104–105.

2. Alice Schroeder, The Snowball (New York: Bantam, 2008).

3. Robert T. Kiyosaki, Rich Dad, Poor Dad (Scottsdale, AZ: TechPress, 2002).

4. Buffett and Clark, Buffettology , 166.

CHAPTER 5

Retained Earnings—The Fuel for the Engine of Compounding Returns Warren Buffett invests in companies that have the ability to retain and compound earnings at high rates of return. Typically, companies with low plant, equipment, research and development costs will meet this mold.

Warren Buffett leaves his money within these companies so that it may compound at high rates of return. In other words, not only does the business in which Buffett invests retain its earnings and reinvest it back into the business, Warren retains his money within these businesses. He does not withdraw the capital from the investment by selling the stock, nor does he necessarily seek out companies with huge payout through dividends. This paradigm of never selling allows him to snowball his wealth and avoid capital gains tax consequences.

In the universe of small business, small business owners also have the option to leave (or retain) their earnings (if they

exist) within the company to compound at high rates of return, if high return reinvestment options are available. If the business does not churn out high rates of return, then the question becomes, is a better investment, one with a higher rate of return, available?

Death of the Compounding Engine

First, the business must have earnings. Secondly, the business must have the ability to generate those earnings using a reasonable base of equity. This results in a high return on equity. Thirdly, the business must have the ability to retain the earnings at the same high rate of return. If a business cannot retain the earnings, then the compounding engine is destroyed.

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.

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