You want to make sure that the companies in which you invest are using their profits wisely with regards to investing. It's not just about making money, it's increasing the value of the business. This is where Warren Buffett's $1 test comes in handy.
Let me share with you the simple test. For every dollar they keep in the company, rather than distributing it to you as a dividend, at least one dollar of value should be created for you, the shareholder. It's sort of a report card on the managers. If they do a good job, the value goes up more than the amount they kept.
So why is this important? If you are buying a stock, essentially what you're doing is you are purchasing a piece of ownership in a company. You want this company to be more worthy in the future than it is today. The $1 test helps you figure out if the managers are making smart choices with the money they keep.
Take ITC, for instance. In the last decade, ITC has managed to create ₹8.7 of value for every ₹1 they retained. That is some good return in my opinion. For Asian Paints, the number is even higher at 14.1x and Voltas is priced at 9.1x. What these numbers are telling us is that these companies are really good at turning retained earnings into further value for shareholders.
It's not the big figures that matter, it's the consistency. Buffett advises screening for this test over a rolling five year period. This helps iron out any short term bumps and gives a clearer picture of how the company is performing.
The best part of the $1 test is how easy it is to use. Right away, you get a feeling for the relative performances of different companies within the same industry. It also makes you appreciate performance of a company over time and not based on a one year performance.
Of course, no test is perfect. Changes in short term stock prices can distort the results and some businesses need to hold more profits in order to grow. That might make them look bad in this test even if they're setting up for future success.
The $1 test by Buffett is an excellent tool for every investor. Using it is easy and just plain simple. It provides a good starting point to look closer at the performance of a company.
