Retained Earnings—The Fuel for the Engine of Compounding Returns
Warren Buffett invests in companies that have the ability to retain and compound earnings at high rates of return. Typically, companies with low plant, equipment, research and development costs will meet this mold.
Warren Buffett leaves his money within these companies so that it may compound at high rates of return. In other words, not only does the business in which Buffett invests retain its earnings and reinvest it back into the business, Warren retains his money within these businesses. He does not withdraw the capital from the investment by selling the stock, nor does he necessarily seek out companies with huge payout through dividends. This paradigm of never selling allows him to snowball his wealth and avoid capital gains tax consequences.
In the universe of small business, small business owners also have the option to leave (or retain) their earnings (if they exist) within the company to compound at high rates of return, if high return reinvestment options are available. If the business does not churn out high rates of return, then the question becomes, is a better investment, one with a higher rate of return, available?
Death of the Compounding Engine
First, the business must have earnings. Secondly, the business must have the ability to generate those earnings using a reasonable base of equity. This results in a high return on equity. Thirdly, the business must have the ability to retain the earnings ...