In one of Warren Buffett's hypotheticals, a family owns a hundred and twenty acres. A neighbor has sixty acres of comparable land. They combine their farms and become equal partners. The enlarged farm covers a hundred and eighty acres, but the family's half amounts to ninety. The enterprise has grown by half. Its original owners have lost a quarter of their claim.
A company can make the same exchange while announcing higher sales and profits. What matters to its owners is the value attached to each share after the transaction. Buffett calls that intrinsic value. It's an estimate of the cash the business can eventually provide for that share, expressed in today's money. Growing the company helps only if what owners receive justifies what they give up.
What the next dollar earns
Some earnings must stay in a business to maintain its competitive position, operating volume, and financial strength. Distributing that money can weaken the operation. With the remaining earnings, management has a choice. Buffett's dividend essay asks whether each dollar retained can reasonably create at least a dollar of market value for owners. The prospect must also compare favorably with what shareholders could earn if they received the money.
Judge the new investment on its own. A wonderfully profitable original business can make consolidated results look respectable while its surplus funds poor acquisitions. Managers who would shift capital out of a weak subsidiary should apply the same reasoning when owners have better uses outside the corporation. Skill at running a factory does not automatically produce skill at deciding where its profits belong.
An owner's need for spending money doesn't settle this choice. If reinvestment can create more value than distributing the cash, the owner may benefit from retention and sell part of the more valuable holding. Conversely, someone saving every dollar can still benefit from a dividend when better opportunities exist elsewhere. The business must earn the case for keeping the money; an owner's personal budget cannot make a poor investment worthwhile.
What an acquisition costs
Paying with shares repeats the farm's exchange. The buyer gives the seller part of its existing business. If those shares trade below their intrinsic value, payment based on the quotation can surrender more economic value than it buys. Higher earnings per share do not prove otherwise. A valuable future earning stream can be exchanged for a weaker one that reports more profit today.
Acquisitions are especially vulnerable to enthusiasm. Size brings status, and a manager may overestimate the ability to transform a struggling business. The seller usually knows the operation better and chooses when to offer it. That calls for patience and comparison with other opportunities. A minority stake in an excellent business may be more attractive than control of another. Having money available is no reason to lower the standard.
Buying back the company's own shares faces a similar test. Buffett requires both money beyond operating and liquidity needs and a price below a conservative estimate of intrinsic value. A lower price retires more shares, increasing the remaining owners' claim on future earnings. Financial strength comes first. Departing owners also deserve the information needed to judge what they are surrendering; their lack of knowledge should not become management's advantage.
Wealth you can use
Eventually, an owner may want cash or a way to give someone else part of the holding. A fair sale of a business changes the form of existing wealth. It does not automatically create more. For someone selling a lifetime's business, the buyer's future treatment of it matters too. A broker paid when the transaction closes has a different incentive from the owner who must live with the decision.
For shareholders, a market price reasonably related to business value helps connect investment results with operating results. An inflated quotation can hurt the next buyer just as an unduly low one hurts a seller. Buffett's aim was to attract informed owners with a long horizon, while keeping practical ways to enter, leave, or transfer ownership.
Berkshire's original Class B shares addressed one such practical problem. The smaller interests made modest holdings and gifts easier. They also countered expensive imitation trusts that would sell Berkshire's past performance to poorly informed buyers while charging substantial fees. This was a particular historical design for access and fair treatment. A share's high price was no achievement if owners needed costly packaging merely to hold or transfer a useful amount.
Taxes affect how much of that wealth can ultimately be used. Deferring a taxable sale leaves more capital working in the investment. The accrued tax is still a real liability, contingent on realization, effectively providing interest-free financing until then. Selling can end that benefit. Recording a tax charge and paying the cash are different events; the rate at eventual realization determines the bill. A higher tax on appreciation can reduce realizable wealth without changing the business's operations.
Tax deferral alone cannot justify keeping an inferior investment when another offers better after-tax prospects. Buffett's patience also reflects business judgment and relationships with managers. The aim is a valuable claim that owners can use or pass on after its costs are met. A larger corporation is useful only insofar as it improves that result.
Three things to keep
Judge growth by the value each owner keeps after capital committed and ownership surrendered.
Retain surplus earnings only when their prospects justify keeping the money from owners.
Spendable and transferable wealth depends on price, ownership design, and the eventual tax bill.