Understanding Retained Earnings, Opportunity Cost and Net Present Value (NPV)
A capital allocation framework
This is the third part of my capital allocation series. You can find part two (for members only) here, or part one (free) here.
What do some of the biggest companies do with the profit they make?
Berkshire Hathaway’s net income was $89 billion last year, Apple $93 billion, and Amazon $59 billion. Regular business owners—including those who own coffee shops, fix cars or sell overpriced mulled wine at Christmas markets—also make profits. What do these businesses do with their profit?
This is the core question concerning capital allocation—what do you do with the profits your company makes?
In the first part of this series we discussed the various options available to CEOs and business owners. Invest profits back into current operations, acquire other companies, pay down debt, buy back shares or distribute it to shareholders.
Running your business operations efficiently forms the skeleton of having a successful business, whether globally or locally—but what you decide to do with that money is the brain.
Today I will take you through Warren Buffett’s “test” for deciding whether to invest profits or distribute them, how Charlie Munger measured all opportunities available to him, and a simple bit of maths that pulls them all together, to give you a framework for deciding what to do with the money your company makes.
How Warren Buffett Thinks About Profits
Warren Buffett has only ever issued one dividend to Berkshire Hathaway shareholders back in 1967, and has historically declined to repurchase significant amounts of Berkshire’s stock—two moves that, when done correctly, increase shareholder wealth.
Why?
Retained Earnings is the cumulative total of all past profits (Net Income) that the company has kept (i.e., not paid out to shareholders as dividends). This cumulative amount is recorded on the balance sheet under Shareholders’ Equity.
The act of retaining the profit is what gives the company the ability to invest it.
Buffett has a simple “test” for deciding what to do with retained earnings: for every dollar of retained earnings he must add at least one dollar of equal value to Berkshire’s market value. If he can’t, he believes it should be issued to shareholders.
Let’s go through Buffett’s “test” with two examples for two fictional companies: ‘Omaha Construction’ and ‘Nebraska Insurance’.
Omaha Construction
On 1 January 2024:
Omaha Construction’s total Market Value is $100 million.
The cumulative retained earnings on its balance sheet is $50 million.
During 2024:
The company earns $10 million in profit.
The CEO, Warren Munger, makes a conscious decision not to issue a dividend.
Instead, he looks to invest the $10 million of retained earnings, believing that he can increase the market value of the company by more than $10 million.
On 31 December 2024:
The company’s new market value is $112 million.
So did Warren Munger pass the test?
Yes. He took $10 million of retained earnings and (very quickly I might add) turned it into $12 million. So, for every dollar of retained earnings he decided not to issue as a dividend, he created $1.20 by investing it. A very nice return of 20%.
Nebraska Insurance
On 1 January 2024:
Nebraska Insurance’s total Market Value is $250 million.
The cumulative retained earnings on its balance sheet is $80 million.
During 2024:
The company earns $7 million in profit.
The CEO, Charlie Buffett, decides not to issue a dividend.
Instead, he invests the $7 million of retained earnings in an acquisition of a smaller local insurance broker.
On 31 December 2024:
The company’s new market value is $255 million.
So did Charlie Buffett pass the test?
No. He took $7 million of retained earnings and turned it into $5 million. So, for every $1 of retained earnings that he invested, he created $0.71 of value. He destroyed $2 million of shareholder value.
This test, to turn $1 of retained earnings into at least $1 of market value, is a hell of a test to consistently pass. I think it also explains why Buffett’s Berkshire has mostly stayed away from technology stocks that are by their very nature—speculative. They place big bets on new technologies that may, or may not, pay off.
The problem with Buffett’s test is that it tells you if you’ve succeeded after the fact. Often though, when thinking about investing your company profits there will be more than one option available to you. So, how do you figure out which option is best?
To help decide which of our options is best beforehand, we need to introduce a concept by the late Charlie Munger.
Understanding ‘Opportunity Cost’
“Proper allocation of capital is an investor’s number one job. Remember that the highest and best use is always measured by the next best use.” — Charlie Munger
Charlie Munger acknowledged that for every choice you make you forgo the alternative options available to you. This concept is called Opportunity Cost.
Similar to inversion, where you turn a problem upside down, opportunity cost asks us to consider the opportunities we could potentially miss out on, as opposed to our traditional way of thinking, which is to solely focus on the thing we want. It forces you to think of the whole picture in that given moment by considering all available alternatives.
Remember, there’s no such thing as a free lunch—everything has trade-offs.
Your business has $2 million of retained earnings you want to invest. You think carefully and decide that you have 4 options to choose from:
Build a new factory: Will likely earn 15% per year.
Buy Competitor: Will likely earn a 12% return per year.
Pay Down Debt: Saves 7% in interest payments per year.
Buy Back Stock: Will likely earn a 10% return for shareholders.
It should be obvious that the first option produces the highest return. A 15% return is better than the next best alternative of 12%. But let’s consider that you chose to buy the competitor instead. Its returns are higher than paying down debt and buying back stock, but it’s not the best use of capital because option 1 returned an extra 3% had you chosen it.
A 12% return isn’t something to turn your nose up at, but this is what separates good capital allocation skills from great. It’s how great businesses continue to grow, year after year, and it’s the single fastest way to solidify the longevity of your company.
So, why do business owners, CEOs and investors consistently choose options that forgo better alternatives? Charlie Munger knew why—human psychology.
Humans might look, walk and talk differently from sheep, but we seemingly share the same part of DNA that, when faced with uncertainty or pressure—and especially when we deem ourselves to be missing out on fortunes—automatically, and unknowingly, falls into step with the rest of the herd.
Even when you realise this folly, it’s like an out-of-body experience. Your body is moving in a direction you know it shouldn’t be—but you can’t stop. Closer and closer to the edge you get, but it’s too late now. Better to be dragged down with others than stand alone in a cold, wet, shitty field.
In my last essay I described this herd-like mentality as the institutional imperative—where CEOs, hedge fund managers and investors follow the crowd even when it’s clear the train’s heading in the wrong direction. They ask themselves “What if they’re right?” instead of asking “How are they wrong?”
Just like the kid who copies somebody else’s homework—but doesn’t pass the test—if you want to be a good capital allocator you need to think for yourself.
Henry Singleton back in the 1960s (who we discussed in my last essay on legendary capital allocators) challenged the then conventional wisdom of issuing dividends. Instead, he decided to buy back most of Teledyne’s shares—something completely alien at the time, that would end up creating enormous long-term value for shareholders. And just like Singleton did, not only do you need to understand what options are available to you, but more importantly—which one produces the best return. To do this, we need to describe the third part of this framework.
How to Calculate Which Investment Project is Best: Net Present Value (NPV)
Why is $1 you receive today more valuable than $1 you receive one year from now?
If you answered inflation, great. If inflation is 3%, then your dollar today would be worth $0.97 a year later. You would have less purchasing power in the future by deciding to wait. You could also have answered risk. There is no guarantee that you will receive $1 a year from now. The company you work for could go under, the bank could go bust, or you could be promised something by somebody, and them not deliver. Humans being humans after all.
If you answered inflation + risk + opportunity cost, then you’ve been paying attention. By deciding to take $1 a year from now, not only does inflation eat away at it, and you run the risk of getting nothing at all, but you also don’t receive any interest you could have earned on it had you invested. If a bank was offering a 4% interest rate, then you would have actually made a small gain by depositing your $1 with them.
Since money in the future is worth less than money today, we need a way to “discount” it back.
Working Out The Present Value (PV) of Future Money
If a CEO has $1 million to invest and finds a bond that pays 7% per year, at the end of year one he will have $1,070,000 ($1,000,000 × 1.07). We have calculated what our money today will be worth in the future.
Now, let’s say a business partner promises to pay you $1.2 million a year from now, but only if they can invest the money, promising the same interest rate of 7%. How much is that future $1.2 million worth to you today?
The answer is $1,121,495 ($1,200,000 / 1.07).
The second option is clearly a better use of capital (not accounting for risk).
This is what’s called calculating the Present Value (PV) of future cash flows. This simple bit of maths allows CEOs, business owners, investors and everyday people to compare what their money is worth today against an investment decision that promises X% interest in return, in the future. If we go back to Charlie Munger’s concept of opportunity cost, then we must use this calculation to determine which of our capital allocation options we must make.
Let’s go through a couple of practical examples to drill this home using our fictional company Omaha Construction.
Capital Allocation Option 1
CEO Warren Munger has $10 million to invest in buying new plant, which he determines will cost and return the following:
The Cost: $10 million of today’s money is needed to fund the investment.
The Payoff: $2 million per year for 3 years.
To make a decision, we have to compare the cost today with the payoff in the future.
Cost Today: -$10,000,000
Payoff:
Year 1: +$2,000,000
Year 2: +$2,000,000
Year 3: +$2,000,000
Because we now know that money in the future is worth less than it is today, you can’t just add the $2 million per year together to get $6 million. We have to “discount” each of those future payments back to today’s value, just like we did earlier with the $1.2 million example. Let’s use a 10% discount rate.
Year 1: $2,000,000 / 1.1 = $1,818,182
Year 2: $2,000,000 / 1.1² = $1,652,893
Year 3: $2,000,000 / 1.1³ = $1,502,630
The PV (Present Value) is therefore the sum of these three numbers: $4,973,705
The ^ is an exponent. What this means is that for the second year we divided $2 million by 1.1 twice. For year 3, three times. It basically represents the number of years we divide the number by.
The Net Present Value (NPV) is the sum of all the present values (the money you’re getting further down the road) minus the initial cost.
TOTAL PV = $4,973,705
NPV = $4,973,705 - $10,000,000
NPV = -$5,026,295
Should Warren Munger invest in this project? Absolutely not—unless his sole focus is to lose a shedload of money. If he were to make this investment, his $10 million upfront cost would be worth just over $5 million in today’s money. Nearly 50% less.
Capital Allocation Option 2
CEO Warren Munger has $20 million to acquire a company that manufactures construction plant, which he determines will cost and return the following:
The Cost: $20 million of today’s money is needed to fund the investment.
The Payoff: $7 million per year for 5 years.
Cost Today: -$20,000,000
Payoff:
Year 1: +$7,000,000
Year 2: +$7,000,000
Year 3: +$7,000,000
Year 4: +$7,000,000
Year 5: +$7,000,000
Using the same 10% discount rate to calculate the PV we get the following:
Year 1: +$7,000,000 / 1.1 = $6,363,636
Year 2: +$7,000,000 / 1.1² = $5,785,123
Year 3: +$7,000,000 / 1.1³ = $5,259,203
Year 4: +$7,000,000 / 1.1⁴ = $4,781,094
Year 5: +$7,000,000 / 1.1⁵ = $4,346,449
The PV (Present Value) of the 5 years’ cash flows is: $26,535,600
The NPV (Net Present Value) is:
TOTAL PV = $26,535,600
NPV = $26,535,600 - $20,000,000
NPV = $6,535,600
Should Warren Munger invest in this project? Absolutely. Today’s $20 million investment in acquiring the plant manufacturer is actually worth $26,535,600 based on his analysis.
A Framework for Making Capital Allocation Decisions
We now have a 3-step framework for making better capital allocation decisions.
Create at least $1 of value for every $1 of retained earnings.
Weigh up all of the capital allocation opportunities available to you.
Work out what their expected returns would be over time, discounting them back to today’s value minus the initial cost. If it’s negative, you’ll more than likely destroy value.
Recently, we applied this thinking to a decision that didn’t involve factories or acquisitions—we hired a junior QS to free up a director’s time for higher-value work. It’s early days, and I can’t yet tell you whether it’ll pass Buffett’s test. But understanding these frameworks changed how I see the decision. I’m no longer just asking ‘can we afford to hire him?’ I’m asking ‘what’s the opportunity cost of not making this hire?’
As ever, there is plenty of nuance to this framework. You heavily rely on your analysis when making judgements about how much a particular investment might make. You set the discount rate, which for one option might be suitable—for another not. In this essay I am also only working out the PV and NPV and make no allowance for other accounting tricks that could swing the numbers in one direction or another.
Things also don’t always work out linearly. An investment you make today looks like it’s done and dusted, but suddenly has a new lease of life and comes to fruition. How many technology companies have had products that were the talking points of everyone’s conversations, only to be blindsided by a newer, better technology completely out of the blue?
As a joint business owner and private investor, it’s crucial that I understand capital allocation. But the more I research the subject, the more I’m convinced by the simple (but hard to practise) wisdom of great business owners and investors from yesteryear: Stick to what you know. Throw in a healthy margin of safety. Wait for no-brainers.
Until next time, Karl (The School of Knowledge).
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