Additionally, distributions result in tax consequences. By leaving the money within the business, distribution taxes can be avoided, whether dividend or income taxes. This is one of the secrets as to how Warren Buffett compounded an initial $105,000 investment into a fortune in excess of $40 billion. His investments have avoided excessive tax bites over the years.
Warren Buffet reasons, “why the heck would I remove the earnings from the investment? If it is generating a good return, I’ll just have to go find another investment generating a good return. It’s not as if I am going to go buy a new car. Plus, Uncle Sam is merely going to take his bite on the distribution, eroding my wealth.” Remember the whole “let me have a dollar” bit from earlier in the chapter? If I have the ability to generate a 15% rate of return on your investment, and I create earnings and give you the option to remove them in order to go buy a brand spanking new car, or to leave them with me to continue compounding at 15% a year, which would you do? If you leave the earnings with me they will continue to grow indefinitely, as long as I have the ability to generate a 15% rate of return (pure Buffett companies with this feature – McDonald’s, Coke, Disney). On the other hand, if you purchase the brand spanking new car, Uncle Sam will first hit you up with a 15% tax bite, the second you drive the car off the lot it will be worth approximately 25% less, and within five years, it will be at 30% of its original value, if you are lucky.
In other words, if you withdraw $20,000 from the business investment, Uncle Sam will cleave $3,000 off of the top, the rest goes towards your $17,000 car which will be worth $5,100 at the end of five years. Net overall return: a loss of 75%.
Versus, if you leave the money with me at 15% a year, at the end of five years, your investment will grow to $40,227. $5,100 versus $40,227 … this method is how Warren Buffett turned an initial $105,000 investment into a $40 billion dollar fortune and how you can build a small business that he will love. It is not to say that you shouldn’t have nice cars. Just understand the opportunity cost of buying a brand new car.
Earnings and high return on equity lie at the heart of Warren Buffet’s super-comounding, investing paradigm. In order to build a small business that Warren Buffett would love, you also must build a super-compounding engine within the business. The more money left on the table, the more super-compounding the business can do.
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