Warren Buffett’s $1 Test: A Simple Formula to Find Quality Companies

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Warren Buffett’s $1 Test

One of the critical choices each business faces at the end of every year is whether to give its profits back to the owners (that’s what dividends are) or retain some money to grow.

Now, if the business is keeping that money, you as an owner better make sure the managers – the capital allocators – are using it well.

But how do you test for that?

That’s exactly what Warren Buffett’s $1 test is all about.

It answers a fundamental question: Is a company creating value or destroying it?

For you as an investor, this matters enormously. When you buy a stock, you are not just buying a piece of paper, but becoming a part-owner of a business. You want that business to grow in value over time.

The $1 test helps you figure out if the company is good at turning the money it keeps into more value for you, the owner.

For managers, the $1 test is like a report card. It shows whether they are doing a good job with the money shareholders have entrusted to them. Are they making wise decisions that grow the company’s value, or are they wasting resources?

Buffett wrote about this test in his 1983 letter to shareholders –

We feel noble intentions should be checked periodically against results.  We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.  To date, this test has been met.  We will continue to apply it on a five-year rolling basis.  As our net worth grows, it is more difficult to use retained earnings wisely.

And then again in his 1984 letter –

For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders – to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention.

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.

At its core, the $1 test is about efficiency and value creation. It’s not about a company getting bigger, but about it becoming more valuable.

This distinction is crucial. A company can grow in size by wasting money on bad investments, but that doesn’t help shareholders. The $1 test cuts through the noise and focuses on what really matters: that great businesses don’t just make profits, but turn those profits into even more value for their owners.

Here’s how it works:

Look at how much money the company keeps (retains) from its profits each year.

See how much the company’s market value increases over time.

Compare these two numbers.

If the increase in market value is more than the retained earnings, the company passes the test. It’s creating value for shareholders. If not, it’s destroying value.

Let me explain with a few simple examples. Here is how ITC, Asian Paints, and Voltas have done on the $1 test based on their last ten years of total earnings retained versus the change in their market capitalisation during this period –

These are some great numbers to look at. ITC, for example, has created ₹8.7 of value over the past 10 years for every ₹1 retained in the business. For Asian Paints and Voltas, these multiples are 14.1x and 9.1x respectively.

But given the kind of market we are in, where market valuations have multiplied over the past few years, most of the businesses you check on this metric will pass the test with flying colours. And that’s why you should add to your analysis what Buffett advised in 1983, that is to apply this test on a five-year rolling basis.

When I do that for these companies, here is the result with the last column representing the years FY19 to FY24, and backward, toward the left columns –

As you can see from ITC’s table, most of its value creation as per the $1 test has been a consequence of the surge in its market capitalisation over the past 3-4 years and its total retained earnings (denominator) coming down due to a generous dividend policy.

For Asian Paints, the multiple has come down due to the stock’s sedate performance, even as cumulative retained earnings have gone up. Voltas, like ITC, has been a beneficiary of the stock’s good performance over the past five years.

One of the key reasons I use this test while analysing businesses is the ‘simplicity’ factor. Of course, there are factors like return on incremental capital you must analyze to identify reasons for a given multiple, the underlying idea of this metric is very simple – whether the company is creating more than $1 (or ₹1) of market value for each $1 retained.

Another factor I like about this metric is that it encourages looking at a company’s performance over time, not just in one year. Third, I can use it to quickly compare different companies from a given industry and see which ones have created better value (and, wearing my contrarian hat, which ones are ripe for value creation in the future).

Of course, like all quick calculations that also hide something behind their simplicity, even this metric suffers from disadvantages. One, as you saw in ITC’s 10-year versus rolling 5-year calculations, short-term stock price changes can affect the test results and your conclusion, especially when you are only looking at a single number (like only 10 years).

Also, some industries and businesses naturally need to retain more profits to grow, which might make them look bad in this test even if they’re doing well or are setting the stage for future success.

But, all in all, Buffett’s $1 test is a handy tool for quickly assessing how well a company is using its profits to create value for shareholders over time. It’s simple to use and can give you a good starting point for further research. Just that, like any investment tool, it has its limits and is best used alongside other methods of analysis.

Buffett’s $1 Test: Automated Spreadsheet

Before I end, here’s a shameless plug for my comprehensive automated stock analysis spreadsheet, which can help you just perform not just Buffett’s $1 test automatically, but also provide many other automated screens for analysing businesses.

Here are some key things this automated stock analysis spreadsheet can help you with –

Pre-Built Analysis Models: So you don’t have to waste hours entering data and maintaining your spreadsheets. The automated spreadsheet does it all and lets you customize it.

Graphs: Visually see the historical performance of the business across various key parameters.

Valuation Models: DCF, Ben Graham formula, Dhandho Framework, and Expected Returns Model – to help you identify a stock’s intrinsic value range.

Quick Analysis: Across key areas like growth rates, earnings stability, financial strength, capital allocation, and efficiency.

Key Metrics: Easily check key metrics like ROE, ROCE, Gross Margin, Debt to Equity, Free Cash Flow, etc. to determine the quality of the business.

Explanations: Explanations of key terms and ratios to help you understand nuances of financial statement analysis.

How to Get this Spreadsheet?

Multiple ways –

You can get it for FREE by joining Mastermind – my most comprehensive value investing course and membership.

You can get it for FREE by joining the August 2024 cohort of my online value investing workshop.

Click here to pay a small fee to get the spreadsheet on a standalone basis (till 15th August 2024, it’s available at a discounted fee of ₹1799).

That’s all from me for today.

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Thank you for your time and attention.

~ Vishal