The Secret to Being Rich in Lifestyle, Not Just On Paper ...

Today, I was working my way through a stack of papers that had grown to about two feet high in my home office and I came across a quote from Berkshire Hathaway Vice Chairman Charlie Munger that puts the entire concept of return on investment in such simple terms, it's still exciting, even after reading it all this time later. "There are two kinds of businesses: The first earns twelve percent, and you can take the profits out at the end of the year. The second earns twelve percent, but all the excess cash must be reinvested - there's never any cash. It reminds me of the guy who sells construction equipment - he looks at his used machines, taken in as customers bought new ones, and says, 'There's all of my profit, rusting in my yard.' We hate that kind of business."

The point I believe he's trying to make is that quality of a business, as measured by return on invested capital, matters a great deal to the standard of living the owners experience. Two men (or women) who own a steel plant and an advertising agency, respectively, are going to have very different purchasing power even if they both show net income of $500,000 on paper at the end of the year. The reason? The guy with the steel plant is going to have to pour money back into maintaining the huge property, plant, and equipment he must have to turn out his finished product. If he doesn't make those investments, eventually the factories will shut down entirely or the product and / or work environment will become so safe, he'll be sued. Contrast that to the gentleman who owns the ad agency. For all intents and purposes, as I've pointed out before, all he needs is a desk and some pencils. He could have an 80%+ dividend policy, and take the money to buy custom suits, fine wines, new cars, or premium real estate, and his firm probably isn't going to suffer any major competitive setbacks.

Even better, if he's determined to grow very, very rich, all of those dividends could be used to expand into other (preferably high return on investment) assets such as whole companies, new startups, stocks, bonds, mutual funds, real estate investment trusts, gold, silver, or whatever else his heart desires. In no time, not only are earnings showered on his head from the advertising agency, but from the investments he's built up from the stream of cash the former provided.

Quick Explanation of Return on Invested Capital
For those who haven't been reading my articles or have just forgotten, here's a very quick and dirty explanation of the concept of return on invested capital, or ROIC as it is often short-handed. Peter Lynch once noted that all businesses have to spend money to make money - some just have to spend more than others. The ROIC figure is giving you a rough idea of how much money, or "capital", had to be put to work to generate a given level of profits.

Imagine for a moment that you want to open an ice cream stand. You expect to make $3,000 in profits but think that you will need about $10,000 to get off the ground. You take $1,000 out of your savings account and borrow the other $9,000 from your brother for a total of $10,000 capital at work ($1,000 of it is owners' equity, or equity capital as it is sometimes called, and the other $9,000 in debt capital). At the end of the year, when you make your $3,000, you can look at down at the figures and calculate an ROIC of 30% ($3,000 divided by $10,000 total capital).

Now, again, this is grossly oversimplified but it's enough to provide a broad outline. A business like this, even if you were dealing with pure equity and had no debt, could provide a fantastic living if you could ever get it large enough to support you and your family. If you wanted to open a store that sold, say, lawnmowers, you'd have to come up with a whole lot more money to buy that initial inventory. If you wanted to grow the company, you'd need to take a big part of your profit and pour it back into expanding your inventory in addition to replacing the units sold to customers. You couldn't just take the profit and go spend it on the things you wanted without hurting the business. That's the whole concept.