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With Berkshire Hathaway, Warren has managed to employ retained earnings at approxiamtely a 23% compounding annual after-corporate-income-tax rate of return. This means that each $1 of earnings that Berkshire retains, will annually produce a 23% return. If Berkshire chose to pay out the 23% to its owners, they would be taxed at personal income tax rates, which would thus reduce the return to approximately 15.9%. Additionally, the dividend payment would put the earnings in the hands of the investor, which would thus burden him with the problem of reallocating the capital to new investments. For the Berkshire investor/owner, the question becomes, Does he want to take his share of the company's earnings as a dividend, or does he want Berkshire to retain the earnings and reinvest them for him? If Berkshire retains the investor's earnings, the investor can expect that those retained earnings will earn a 23% annual rate of return. And under Warren's theory, the underlying value of Berkshire would increase by 23% as well, which over time will cause the market price for Berkshire's stock to increase, which, in turn, benefits the shareholder/owner. Following this line of thinking, Warren has come to the conclusion that common stocks bear a resemblance to bonds that have variable rates of return, depending on their earnings for a particular year. And he has realized that some common stocks have underlying businesses that create consistent enough earnings to allow him to project their future rate of return. In Warren's world the common stock takes on the characteristics of a bond, with the payable interest being the net earnings of the business. He calculates his rate of return by dividing the company's annual net per share earnings by the price he pays for the stock. A $10 per share asking price for the company's stock against annual net per share earnings of $2 a share equates to a rate of return of 20%. Understand, though, that the integrity of this calculation is wholly dependent upon the predictability of the company's earnings. In real life, if you were to buy a local business you would want to know how much it earned each year and how much it was selling for. With those two numbers you could calculate the annual rate of return on your prospective investment by simply dividing the business's yearly earnings by its asking price. Warren does this type of analysis whether he is buying an entire company or one share of a company. The price he pays determines his rate of return.

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The Price You Pay Determines Your Rate of Return The price you pay determines your rate of return. This is the key that you should wear around your neck at all times. It is the one tenet of Graham's that Warren lives by. Before I go any further on the subject of price and the rate of return, I must warn you that I am going to simplify a few things for the sake of explanation. I know that a great many of you have some experience in the world of finance and will be biting to debate me on certain points. To those of you who fit this description, I can say that later in the book I will go into detail on the finer points. But for now I must get past a few of the basic concepts so that everyone can easily grasp the later chapters without getting the glazed look that comes from reading an accounting text. So let's use a very oversimplified hypothetical case to start. (You of the experienced category should also pay attention to the following because some of the basic tenets are contrary to the conventional wisdom peddled by Wall Street.) Let's start by asking a simple question: If I were willing to sell you the right to receive $1,100 at the end of one year, what is the maximum you would be willing to pay for this right on Day 1? If you paid me $1,100 and I paid you back $1,100 at the end of the year, the return on your investment for the year would be zero. However, if you paid me $1,000 for the right to receive $1,100 at the end of one year, your return would be $100 above the $1,000 that you paid me, which would give you a return of 10% on your money for the year. Now, your next question is whether or not a return of 10% is a good rate of return when compared to other rates of return. To determine this you need to shop around a bit. You might find that the local bank is willing to pay you 7% on your money if you deposit it there for one year. This means that if you loaned the bank $1,000 for one year, it would at the end of that year give you back $1,070 which equates to a $70 profit, or a rate of return of 7%. Obviously, the 10% return on your money that I offered you is better than the bank's 7%. If you looked around at a lot of different investments and still found that the 10% return was a higher rate of return than other investments were paying, you would conclude that I was offering you a better deal than the others. Then, in answer to our question what is the maximum you would be willing to pay today for the right to receive $1,100 in one year? if you wanted at least a 10% return on your money, the maximum you would be willing to pay is $1,000. If you paid more say, $1,050 your profit would be less, by $50, and your return would be less as well ($50 $1,050 = 4.7% return). If you paid less say, $950 your profit would be $150, and your return would be greater ($150 $950 = 15.7% return). The higher the price, the lower the rate of return. The lower the price, the higher the rate of return. Pay more, get less. Pay less, get more. Financial analysts use a mathematical equation called discounting to present value to solve problems like this. This equation allows them to plug in the future value (as in our example), the rate of interest desired, and the time period, and to come up with the present value. Using this equation is extremely time consuming, often involving a series of calculations and the use of tables. To fully understand its use one must usually take a college course in finance or business math. Fortunately, as mentioned, the folks at Texas Instruments have programmed the equation into the BA-35 Solar calculator, so you and I have only to learn how to punch buttons to come up with the present value. Or, if we want, we can find out the future value of a sum growing at a rate of X for Y number of years. We can even figure out the annual compounding rate of return on an investment if we know (1) the present value, (2) the future value, and (3) the holding period of the investment. And since projecting an annual compounding rate of return on an investment is the key to understanding Warren, I recommend that you acquire one of these useful and reasonably priced instruments now. Wal-Mart carries them, as well as most office supply stores and university bookstores. If you can't find one at a store near you, you can order one over the phone by calling Office Depot at 1-800-685-8800. Please note: Several other financial calculators out there will also perform similar calculations. (In case you are wondering, Wall Street analysts long ago quit cranking out present and future value calculations by hand. They also use financial calculators today.) When evaluating what a business is worth, Warren goes through a thought process much like the one we just went through. He takes the yearly per share earnings and treats them as the return that he is getting for his investment. So if a company is earning $5 a share and the shares are selling for $25 a share, Warren perceives this as getting a 20% return on his money for the year ($5 $25 = 20%). The $5 can either be paid out by the company by way of a dividend or be retained and utilized by the business to maintain or expand operations. So if you paid $40 for a share of stock and it has yearly earnings of $5 a share, Warren would calculate the annual rate of return on this investment as being 12.5% ($5 $40 = 12.5%). In keeping with this line of thought, a price of $10 a share with yearly earnings of $5 a share would equate to a 50% return ($5 $10 = 50%). The price you pay will determine the rate of return. One thing that should be readily apparent is that strength and predictability of earnings are an important consideration if you are considering holding a stock for any length of

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23-Oct-10