The power of reinvesting: Why return on incremental capital matters

Imagine you inherited $100,000 and wanted to invest it in a savings account to earn a return. You have two options in your town: one bank pays 8% but doesn't allow you to reinvest, while the other bank pays 5% on your initial deposit, but allows you to reinvest your earnings at 12%. Both banks require a 25-year commitment and your investment is insured and safe. Which option would you choose? Warren Buffett used this example at the 1992 Berkshire Hathaway shareholder meeting to demonstrate the importance of understanding the basic mathematics of investing. Although it's a simplified example, it highlights the importance of considering growth and value when considering a prospective investment. When you consider this example closely, you might find that the second account would be more valuable even though the initial rate of return at the first bank is higher. The ability to reinvest your earnings at 12% over the long term makes a huge difference. If we apply this analogy to stocks, the first bank would represent a stock selling at 1x book value with an 8% return on equity, which pays out all its earnings in dividends. The second bank account would be a stock selling at 2.5x book value with a 12% return on equity. Although you would pay a premium of 2.5x net worth, your earnings on average carrying value would be reduced to 5%. But, the compounding of retained earnings at 12% over time would be extremely valuable. This example shows the importance of investing in businesses that generate a high return on incremental reinvested capital over the long-term, even if it means paying a premium to do