In an era where there is an oversaturation of financial information, most of the value investors tend to get confused with what to analyze and look for while investing in a company. Here comes the metric that Warren Buffett uses to select any stock.
For a shareholder, value is created in two ways: either by receiving dividends on their stocks or capital appreciation. As per Warren, when a company retains ₹1 of the net income, its market value must appreciate at least by ₹1 to pass the $1 test. Couldn't understand a thing?? Read further, and you will get your answer.
“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.” - Warren Buffet, shareholder's letter 1984
What Warren means here is that companies should retain the earnings only when a $ in the company's hand is more valuable than a $ in the shareholder's hand. This happens only when the retained earnings are reinvested into the business to generate incremental income/incremental return on capital.
Markets reward the businesses that create wealth and value over time. So choose a business whose intrinsic value will multiply over time. And the intrinsic growth of business will depend upon the returns it can earn on its additional capital investments. Additional capital investment should generate additional returns. Here comes a new character—ROIIC.
ROIIC demonstrates what additional returns the company earned on your additional invested capital, basically showing an efficiency of utilization of additional capital. When the ROIIC is higher, the company serves as an engine to compound its intrinsic value.
“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.” ~ Warren Buffett
But how do you even analyze or test if retained earnings are being utilized properly?? Here we use a $1 test.
In Fig. (1) you can see the steps to evaluate $1 test;
Calculate retained earnings over the past five years.
Calculate the change in market cap for the very same period.
Divide total earnings by change in market cap.
If the value is more than 1, then the company has passed the $1 test and can be considered for further evaluation.
Warren always preferred to invest in the businesses that keep investing their retained earnings on a return on capital that is more than the cost of capital.
Usually it is recommended that at least 5 years of historical data be required to efficiently run the test. However, value investors does rely on various other factors as well, as this test does have some limitations;
Sometimes a $1 test gets affected by the cyclicity, seasonality, market conditions, or economic factor—you really do need to have a grasp of the industry and macros to be able to interpret it accurately.
Next time while evaluating a company, just don't forget to use the $1 test, which tells you the story of your company - if it's creating additional market value for retaining a ₹.
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