One of Buffett’s favorites
If you have been to the Berkshire annual meetings, or watched any of them online, you might have heard Buffett say that growth is “a part of the value equation”, but that growth by itself doesn’t tell you whether or not a company is an attractive investment. You might also have heard him say that a superior company is one which requires very little tangible capital to run its business. I personally think that these two insights are foundational insights to Buffett, in the sense that it is how he has created so much value over time.
In this article we will focus on one type of investment that has been foundational to Berkshire over the years. It is the “cash cows”, the perpetual bond-type companies that generate steady cash flows on a very small asset base. These companies require very little tangible assets in order to run their business, and are often able to grow their earnings over time without putting much, or any, new capital into the business. Since they don’t need to reinvest their earnings into the business, they can distribute all of their earnings as dividends to Berkshire, which then reallocates this capital into other situations, thus creating even more value over time.
How the math works
Not all growth is good, and two companies growing at the same rate over a ten-year period can differ quite significantly when it comes to the value created for the investor. How is it, that a company growing at 10% per year over 10 years can create little to no value, while another company can grow at the same rate and create significant value over time? Well, the answer lies in the different capital needs of the two businesses.
The following examples will show two different companies that both grow by their earnings by 10% per year, but end up giving the investor hugely different total returns because of how they use their capital.
Company A
The company has earnings of $100 million in year one. The company grows its earnings by 10% every year for the next 9 years and reinvests all of its earnings in order to do so. Let’s assume the investor pays $1 billion for the company, at a P/E of 10, and sells the company at a P/E of 10 at the end of the period. What is the total return for the investor in Company A?
This is how the earnings will look like (all values in million $):
| Year | Earnings |
| 1 | $100 |
| 2 | $110 |
| 3 | $121 |
| 4 | $133 |
| 5 | $146 |
| 6 | $161 |
| 7 | $177 |
| 8 | $195 |
| 9 | $214 |
| 10 | $236 |
The earnings in year 10 will be $236 million, and assuming the investor sells the company at a P/E of 10, he will sell it for $2 360 million. Based on the purchase price of $1 000, that is a nominal return of $1 360 million over the period. Assuming the investor is an individual, and assuming he pays a 20% capital gains tax, he will pay capital gains tax of $272 million (20% of 1360). The total after tax return for the investor will therefore be 1360 – 272 = $1088 million.
Company B
Company B has earnings of $100 million in year one. The earnings grow by 10% per year for the following 9 years, but since this company doesn’t need any more capital to grow its business, it will pay out all of its earnings to the investor as dividends. Because the investor in Company B receives 100% of the earnings as dividends, he will able to reinvest these dividends into other assets. For simplicity’s sake, imagine that the investor reinvests the dividends he receives from Company B into corporate bonds yielding 8% per year over the full period. Of course, since he’s an individual, he will have to pay taxes on the dividends he receives, so let’s assume he pays 30% taxes on the dividends.
Calculating the total return for Company B
Earnings and stock appreciation: Just like Company A in the previous example, the earnings will be $236 million in year 10, and if we make the same assumptions about multiples and capital gains tax, the total “stock” return will be $1088 million, just like Company A. Again, this return comes from buying the company for $1 billion at a P/E of 10 when earnings were 100 million, and selling for $2,36 billion at a P/E of 10 when earnings are $236 million.
Reinvested dividends: Since the investor in Company B receives all of the earnings as dividends each year, one has to calculate the return he gets on the reinvestment of these dividends. As previously mentioned, we will assume he pays a 30% tax on the dividends and then achieves an 8% return each year on the reinvested dividends.
The following table shows the future values of the dividends received over time. (All values in million $).
Year | Dividend | After tax dividend | Future value of dividend |
|---|---|---|---|
1 | 100 | 70 | 70×(1.08)9 ≈ 140 |
2 | 110 | 77 | 77×(1.08)8 ≈ 143 |
3 | 121 | 85 | 85×(1.08)7 ≈ 146 |
4 | 133 | 93 | 93×(1.08)6 ≈ 148 |
5 | 146 | 103 | 103×(1,08)5 ≈ 151 |
6 | 161 | 113 | 113×(1,08)4 ≈ 154 |
7 | 177 | 124 | 124×(1,08)3 ≈ 156 |
8 | 195 | 137 | 137×(1,08)2 ≈ 160 |
9 | 214 | 150 | 150×1,08 = 162 |
10 | 236 | 165 | 165 |
Calculating the total return for Company B
At the end of year 10, the investor in Company B will have received $1 593 million in dividends before tax, or $1 117 million after tax. Due to the investor being able earn a 8% each year on the reinvested dividends, the return achieved over the 10-year period ends up being $1 525 million, the number we get from the sum of all dividends received adjusted for the future values (far right column).
We previously calculated that the investor in Company B achieved a $1 088 million after tax return in the stock just like the investor in Company A, and we now have to add the return the investor got by reinvesting the dividends he received from Company B.
1 088 + 1 525 = 2 613
The total return for an investor in Company B is therefore $2 613 million, compared to $1 088 million for the investor in Company A. Even though both companies grew their earnings by the same amount over a 10-year period and ended the period with the same earnings and market cap, the capital-light business earned the investor a much higher return, because it didn’t need to reinvest its earnings to grow. The investor could therefore benefit from the earnings being paid out to him every year, allowing him to reinvest them, thus creating more value over time.
Even when assuming an 8% return on the reinvested dividends, a return many investors would call subpar, the total return massively outpaces the return one gets by investing in the company that has to keep all of its earnings to keep growing. In theory, the investor could have reinvested the earnings back into the company and achieved a higher total return, or invested in higher yielding situations and achieved still higher returns.
It is also important to point out that a holding company like Berkshire Hathaway would naturally achieve a much higher return, since they wouldn’t have to pay the 30% income tax on the dividends the individual investor has to pay. It is easy to see then, why Buffett loves these capital-light businesses.
Another thing to point out is that there are many ways a company like Company B can create even more value. Had the company bought back shares over time, it may have created even more value. But since the returns of share buybacks are hard to calculate (due to the fact that one has to make multiple assumptions), it’s best to leave that out of the calculation here.
Practical examples
Previous examples have been theoretical. The following are examples of two real companies whose growth in earnings exceed their need for capital investments.
The first example comes from Buffett himself. At the 2011 Berkshire annual general meeting, Buffett was asked what type of business he would prefer to own during inflationary times. He mentions that companies with low capital needs are superior in times of inflation, and reminds the listeners of the struggle of capital-heavy businesses that has to continuously plow capital back into the business at ever higher prices. He then contrasts this to their investment in See’s Candies, a manufacturer of candy.
Buffett mentions that when they bought the company, the company did $30 million worth of sales on a capital base of $9 million. In the year 2011 the company did over $300 million of sales on a capital base of $40 million. In other words, the revenues increased by ten times while the tangible capital in the business only increased three times. Since they haven’t had to reinvest huge sums of capital back into See’s, they have received lots of cash from the company that they have been able to invest in other places.
The second example is Dropbox. It’s a company that offers cloud storage and “digital work solutions” for individuals and small enterprises. In the year 2016 the company had $444 million of property, plant and equipment (net) on their balance sheet, and revenues of $845 million. In the year 2023, the company had $493 million of property, plant and equipment (net) on their balance sheet, and revenues of $2,5 billion.
So, for roughly $50 million of investments in tangible assets, an increase of 10%, their revenues grew about $1,6 billion, or 200%. Their cash from operations grew from $253 million to $784 million in the same time, an increase of roughly 300%.
This is clearly a company that can grow without heavy investments in tangible assets. True, they do need to invest in servers (where the customer data is stored), but the actual capital needed for the servers does not scale in proportion to their earnings potential. In theory then, Dropbox could distribute most of its earnings every year and still keep growing. That being said, this does not automatically make Dropbox an attractive investment.
The main asset of a company like Dropbox is its employees, and while it doesn’t have to invest a lot of capital in hard assets, they may have to invest in R&D every year, which could be seen as a real capital investment, even though it doesn’t show on the balance sheet. Their overall cost for wages could increase in such a pace that the result of growing revenues gets diminished.
Exceptions to the rule
While it is true that a capital light-business can provide an investor with superior returns, it is not always the case. In our theoretical examples we used the same growth rate for both companies. If we instead assume that Company A (the company that reinvests all of its earnings) is able to grow by 20% every year, the earnings at the end of year 10 would be $516 million instead of $236 million. Assuming the investor sells the company for $5 160 million (at a P/E of 10), his total return after paying capital gains tax would be $3 328 million instead of $1 088 million that it would achieve by growing 10%. It is also higher than the $2 613 million the capital-light business achieved while growing 10% per year.
So, obviously, if a company is able to achieve high returns on incremental invested capital, it may be better a better investment than the capital-light business that earn only average returns. And the fact is that many times, capital-light businesses are somewhat limited in their ability to generate growth through investment initiatives. Think of Dropbox for example. They could choose to double their capital expenditures and invest in more server capacity, but that wouldn’t magically generate more customers. And Berkshire could decide to open three more production facilities at See’s Candies, but that wouldn’t increase their sales volume by much. In theory then, companies who has the option to plow back capital into the business at high returns year after year could be superior investments.
Conclusion
If you have two companies that grow at the same rate and will continue to do so for a long time, choose the company that needs to employ the least amount of capital to achieve that growth. But there are both pros and cons with these types of companies, and one has to be an active interpreter of the facts in order to come to a conclusion. At the end of the day, every situation is unique.