How to Reinvest Earnings

Capital Dilemma - Superior Returns - Market Value - Capital Allocation - Margin of Safety

Hello, I am Nicolas Bustamante. I’m an entrepreneur and I write about building successful startups.

Check out some of my popular posts:

Intelligent CEO

The Impact of the Highly Improbable

Surviving Capitalism with Competitive Moats

Subscribe to receive actionable advice on company building👇


previously wrote that "The Intelligent CEO has few options to deploy capital, including investing in the existing business, acquiring other companies, issuing dividends, paying down debt, or repurchasing stock." Today, I want to dig more into the reinvestment of earnings in the business. 

Reinvesting earnings into the business makes sense because it's easier to allocate capital into a business one knows versus investing in another company. Such investments might create a better product, support international expansion, reach new customers or widen the competitive moats. If the company has a lot of growth potential, it is reasonable to reinvest earnings to generate more cash later. As Buffet wrote in his 2019 letter: "Reinvestment in productive operational assets will forever remain in our top priority." Cash compounds faster when reinvested intelligently. The issue is, at which rate of return? 

Warren Buffet often complains that too many CEOs reinvest in their business at below-average returns. If so, the solution is simple according to him: "If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained." Better not inadvisedly retained the precious earnings! The idea is that the company must earn a higher rate of return on the retained earnings than the shareholders could earn elsewhere. Buffet's rule is that every dollar retained must create at least one dollar of market value. He wrote in his 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."

The challenge is that a good company can generate strong cash flows, but the returns on incremental investments might be too low to justify a reinvestment. For example, imagine a company with $10m of earnings and a market capitalization of $100m - which is a P/E of 10. If the company earns a 5% return on $10m, it will generate $500k of earnings growth, thus adding an extra $5m of market capitalization. Therefore, it will be a bad deal for shareholders who can find better investment alternatives such as the S&P500. Alternatively, if the company generates $2m of earnings growth, it will add $20m to its market cap generating an excellent return for shareholders. In this latter example, $2 of market value was created for each $1 retained. 

I want to point out a crucial element: the method to transform earnings into a market capitalization value. In the preceding examples, we use the price-to-earnings ratio. However, sometimes, reinvestment seems to make sense only because of the high ratio. A management team can waste capital in a bull market fueled by speculation due to a historically high multiple. Therefore, when considering earnings reinvestment, the Intelligent CEO should opt, in my opinion, for a historical average ratio. The Intelligent CEO will be confident that the reinvestment makes sense in both a bull and a bear market. In short, the master of capital allocation always has a margin of safety! 

Another challenge is that a company might have a good and sustainable return on reinvested earnings but a low reinvestment capacity. A capital allocator wants thus to know the rate of return and the amount of excess cash the company can reinvest. For example, if a business can generate 10% of incremental returns on capital while reinvesting 50% of its earnings, the intrinsic value will compound by 5% annually (10% x 50%). If another business generates 10% of incremental returns on capital while reinvesting 100% of its earnings, the business's intrinsic value will compound by 10% annually (10% x 100%). The return on invested capital is the most crucial factor, but the reinvestment capacity matters too. Buffet wrote in his 1992 shareholder letter that: "Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return." 

Measuring the rate of return on reinvested earnings is not easy. The first concept to understand is the return on invested capital (ROIC), which measures how effective a company is at turning money into profits. The ROIC formula is net operating profit after tax minus the invested capital. What is interesting is to compare the ROIC with the cost of capital, as measured by the weighted average cost of capital (WACC). The latter is an addition of the cost of debt plus the cost of equity. The cost of debt is the interest rate, while the cost of equity is the rate of return an investor expects - which is subjective. If a business has a higher average cost of capital (WACC) than its return on invested capital (ROIC), it destroys value. Inversely, the Intelligent CEO who borrows at a WACC of 9% to reinvest and earn a 21% return is creating value. Another interesting measure is the return on incremental invested capital (ROIIC) - for instance, our reinvested earnings. This measure tries to dissociate the cash generated by precedent investments versus future ones. 

All those calculations can be complex and misleading. As Charlie Munger says: "I've never heard an intelligent cost of capital discussion." Berkshire Hathaway uses a 10% hurdle rate for the cost of capital, which is an approximation. Similarly, in my opinion, the expected return on investment should be higher than the historical average S&P500 returns. The return on invested capital determines the long-term intrinsic value of a business. Quoting Charlie Munger again: "In the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much difference than a six percent return-even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive-looking price, you'll end up with one hell of a result."

To sum up, cash flows are great, but reinvestment opportunities with a great return rate are even better. If the rate of return is inferior to, for instance, the historical average of the S&P500, then shareholders will be better off investing elsewhere. It's rare to find growing businesses that can create more value by reinvesting their earnings. It's even rarer to find management teams that are conscious of the cost of capital and the necessity of having a reasonable rate of return on reinvested earnings! 


Anonymous survey: What would have made this article more helpful?

If you found this article valuable, please consider sharing it 🙌

Share