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Welcome to Insight Markets! Today we'd like to introduce you to a metric from Warren Buffett: the one- dollar test. This one-dollar test is a relatively simple metric used to assess whether a company has fundamentally earned our money—that is, whether we should invest in it or not. The test isn't very well-known, but today we'd like to explain the basic principle behind it, present the calculation method, and show you an example.
We've chosen Cosco shares for this purpose and are curious to see the results. First of all, what's the idea behind every investment in life, whether it's a real estate stock or further education? We have to ask ourselves: How much money am I putting in? That's what I have at my disposal, but how much will I get back for my money?
And if I look at the investment sector, for example, how do those in charge handle my money? If we consider ourselves long-term Bayern Munich investors, our goal might be to collect dividends, but also to ensure that our shares grow in the long term. That means they... To generate share price increases, shareholder value is created, and for stocks, we must always ask ourselves: Management is in a position and has the responsibility to handle our money carefully, and how well do they achieve their goal of creating this shareholder value?
This one dollar is a simple and good metric for this, largely developed by Warren Buffett. How is this calculated? We always consider a ten-year period. This has two reasons: firstly, it eliminates short-term fluctuations, and secondly, the data for ten years is usually reliable and later includes dividend payouts.
Furthermore, ten-year data is usually readily available, which is why it's a good metric for us. First, we need to calculate how the market capitalization developed over these ten years. Now, let's jump to the example of Cosco and see, for instance, that the share price developed very well from 2011 to 2020.
This means that if we simply assume the number of shares is constant, and then take... Market capitalization is simply calculated by multiplying the share price this year by the number of shares, and then doing the same for the previous year, which is the period we're considering. In this case, it's 2020.
You take the share price (which is quite long) and multiply it by the number of shares. The difference between these two values is the increase in market capitalization. That's the first point. Now we also want to know how much profit our company has made. Depending on the profit, many companies, for example those that retain their profits, distribute a large portion of this profit as dividends.
Other companies, like Amazon, keep almost everything in the company and reinvest it directly. This naturally leads to the company generating more revenue and more profit, which in turn increases the share price and, consequently, the market capitalization. So, we need to consider how much profit the company has generated over the past ten years.
This can simply be added up. In 2011, so much was paid out, and in 2000 versions, so much was paid out. Then we subtract the dividend payments, meaning we actually know: okay, from this profit minus the dividends, that's the money that can be reinvested. And how well does the company manage this retained profit?
Next, we take the increase in market capitalization and divide it by this retained profit. This is a number that ultimately provides a great test, because ultimately, as entrepreneurs, if we want to invest one euro, we ideally want to get a return of a century. Okay, maybe unrealistic so far, but we definitely want to get more than just one euro back.
That's the fundamental entrepreneurial goal, and that's exactly what this formula calculates for me. Because here, as a metric, I have the increase in market capitalization divided by this retained profit. And then I see that if I say the value of the company is characterized or described by the market capitalization, then if this value is greater than one dollar, then this retained dollar has disproportionately increased the market capitalization.
This contributed to the company's value, which is why this should be a great test for the company, landing at a dollar. Now, of course, if the share prices perform very, very poorly, then this metric will be significantly distorted. Similarly, due to the Fed's very expansive monetary policy, all the money that flooded the stock markets—share prices that are perhaps a bit exaggerated—will also lead to a slightly exaggerated increase in market capitalization.
Therefore, one has to be a bit careful here, and it's always worthwhile to compare different companies because these external factors, such as general stock growth, either benefit or suffer, ultimately affecting most companies. Now, let's take an example. As I said, we'll use Cosco stock as an example, and first, we'll calculate average share prices for the increase in market capitalization.
We'll proceed relatively pragmatically here. We'll simply look at the year 2020, the opening price of the year, and the closing price. We'll just roughly go to the middle. It doesn't really matter down to the dollar, so let's just use $340 as the value for 2020. We do the same for 2011, taking the middle group and $80 as the median value.
This means that for the increase in market capitalization, the Cosco stock had 444 million shares in 2020, multiplied by the price of $340. In 2011, it had 443 million shares, almost the same number, but some shares were bought and sold in between, but it remained relatively constant. Multiply by $80.
Then we need the total profit that was generated, which was $ 25,000, or $469 million. The profit distributions over the years weren't particularly high, but we still have to consider that they amounted to $ 7,000, or $432 million. The retained earnings are now profit – the dividend payout – and now...
Just one last step: we need this number here and the one I have up here. Now we simply divide the increase in market capitalization by the retained earnings, and we get a result of 6.4. That's obviously a very good value. That means every retained dollar has essentially contributed $6 to the increase in market capitalization over the last ten years.
And that's certainly a value we're happy about, and it's certainly nice. But as I said before, we have to be a little careful because, of course, the market capitalization has also increased very, very well here. That means we might want to look at it a bit more conservatively, but I would n't do that.
But you could also just calculate the last share price a little lower, always 300 instead of 340. We could also do 250 instead of 340. All you can see is that the trend is always the same. The management in this company is definitely handling the profit very well, and that's ultimately reflected in the share price.
Finally, I'd like to show you a chart that now... This graphic is a bit older; we made it for Twitter. It does n't yet include the 2020 figures, but here we compared different companies. For example, if I have a choice – this was an arbitrary selection of companies – but if I have two comparable companies, like Kimberly-Clark and Churchill, both operating in the non-cyclical consumer sector, and both have relatively similar values, the Altria stock is now being compared.
This is my hot list or watchlist; the worst-performing stock would be Clorox, and the best-performing. So you can compare and consider this. We also did an analysis of the stock in 2009/10, and it had a very high dividend payout, but the $1 test only yielded 0.7. Therefore, you can say, "Okay, the dividend is more important to me," but if you strictly adhere to this metric, you should actually avoid the stock altogether.
In this sense, we hope that this metric might find its way into one or more of your analysis tools, and we look forward to the next video with you. In the meantime, take care of your money. See you soon!
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