One Dollar Test

“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.”

September 15, 2023

Welcome to the thirty-eight Pari Passu Newsletter.

Things are starting to get busy after the summer, so let’s not waste time and let’s dive into today’s learnings.

One Dollar Test

Capital allocation refers to the process by which a company decides how to distribute its financial resources (mainly its cash and its retained earnings), to its projects, investments, or other activities. For investors, understanding a company's capital allocation strategy is crucial as it offers insights into the company's priorities, growth prospects, and overall financial health. When a company allocates its capital wisely, it can lead to increased shareholder value and a stronger financial position in the long run, a theme that Warren Buffett tends to really admire and highlight within companies. In Buffett’s 1983 letter to Berkshire Hathaway shareholders, he speaks to his perspective on capital allocation with, “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.”

What Buffett described is the One-Dollar Test, a method to affectively make sure that the management of a company is effectively allocating capital and resources in which derives legitimate value for shareholders, whether that is in the form of the increased intrinsic value of the business over time or the payments to shareholders through dividends. The essence of this test is that for every $1 of earnings retained by a company, it should translate to at least $1 in market value over time. If a company cannot achieve this, it might be better off returning the cash to its shareholders. Buffett uses a 5-year rolling basis for this concept, viewing the market as an accurate judge of intrinsic value over extended periods. So, how do we correctly perform the One-Dollar Test, and what do the results tell us as investors?

One-to-One

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