Warren Buffett’s name is synonymous with investment success. When people discover that Buffett is buying a stock, it brings a whole new light to that particular company. Because of his success, he’s been properly named “Oracle of Omaha.”
Many would consider Buffett the best investors of all-time, noting that his investing ideas are based on fundamental value investing, an approach that is methodical, yet dull. People admire his success is consistent and long-standing success.
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Buffett’s Pinball Machine Business
Would you have guessed that Buffett’s earliest ventures was a pinball machine business? He himself, has even referred to his early pinball company success jokingly saying that everything after it has been downhill. Let’s jump into this story and pinpoint some of the early discoveries that Buffett made in terms of characteristics of successful businesses.
Buffett’s first business, “Mr. Wilson’s Coin-Operated Machine Company,” was founded at the age of 17 with his high school friend, Donald Danley. It started with Danley purchasing a pinball machine for entertainment. Buffett had the entrepreneurial idea to place it in a barber shop and split the profits with the owner – and it worked! Danley loved to tinker on machines, and he learned to repair the pinball machines as they would break, so they had that part of the business covered. They needed someone to keep track of the books and deal with the barbers and that’s where Buffett came in. Buffett and Danley now had a business where they could purchase, service, and place the pinball machines in barber shops and get a 50/50 split with the barbers.
Buffett’s account of this business has been documented in multiple books and publications, and from these we can put together a picture of the fundamentals what they called, “Mr. Wilson’s Coin-Operated Machine Company.”
Let’s dig in.
Danley purchased the first pinball machine for $25, and other machines ranged from $25-$75 each. To make this exercise simple, let’s assume the average cost of each machine was $50, including any necessary repairs, which was an upfront cost of $50. We also know that in their first week, 1 machine had $14 dollars in it. So, we’ll use this as a baseline for earnings per week. In addition, the machines were constantly breaking, and Danley had to make repairs – so let’s put a number on parts at $1.50 a week per machine. In this finance world, this would be considered CapEx or a capital expenditure – an ongoing expense that is necessary to preserve income.
Let’s take a look at the breakdown from the cash generation from the pinball machine:
The 50/50 split with barbers would provide $7 per week in revenue. And with the operating costs of $1.50, it brings us in at $5.50 per week operating cash flow.
So, the Wilson’s pinball machine’s cash flow stream, looks like this:
- First, there is a $50 ‘cash outflow’ (to buy the machine).
- As the machine continues to generate profits for its owners, this will be followed by a weekly ‘cash inflow’ of $5.50.
- This is the first sign that it was a great business.
- With a $50 cash outflow and $5.50 inflow, we get an approximate 9-week payback period ($50 / $5.50). Meaning, after roughly 9 weeks, all the income is pure profit.
Core Ideas #1 & #2 of a Successful Business
From this simple example, we can illustrate 2 core ideas of a successful business.
#1 – Primarily, successful businesses have high rates of return on investment. The money put into these types of companies quickly pays for itself, and then some, as they generate a substantial amount of profit for their owners.
#2 – Great businesses have low Maintenance Capital Expenditure (CapEx) requirements. This allows cash flow from operations to easily cover costs and generate a profit. Our pinball game, for instance, cost $1.50 per week in CapEx, and generated $7 per week.
Maintenance CapEx / Growth CapEx
Buffett likes to distinguish maintenance CapEx from growth CapEx.
- Maintenance CapEx: money that HAD to be put back into the business to keep revenue flowing, usually in the form of maintaining old equipment.
- Growth CapEx: money put back into the business to ‘grow’ future revenues.
Buffett’s famed company Berkshire Hathaway was originally a textile company; it had equipment that made materials. It generated a fair amount of revenue, but all that revenue would constantly get eaten up by maintenance CapEx. Eventually, Buffett gave up on the business for this reason, but kept the name of the company for his future ventures.
Back to the Pinball Story
Now, Buffett and Danley made $5.50 every week from each pinball machine.
They had a nice income stream of $2.75 a week for each of them. Many kids at that time probably would have been happy and stopped there. Not Buffett. Instead, they decided to reinvest the money and purchased more pinball machines. So, in a little over 9 weeks, they had the capital to purchase a second pinball machine that provided the same cash flow of $5.50 a week without having to add any additional capital to the business.
This is where it starts getting interesting.
With 2 pinball machines operating they were earning $11 a week. This cut the time to down to purchase a third machine to under 5 weeks.
Do you see where this was going?
Pinball machine #2: ~9 weeks later
Pinball machine #3: ~4.6 weeks later
Pinball machine #3: ~4.6 weeks later
Pinball machine #4: ~3 weeks later
Pinball machine #5: ~2.3 weeks later
Each additional pinball machine reduces the time to purchase the next. This is the idea of using compounding to grow a great business.
Core Idea #3 of a Successful Business
#3 – Wonderful businesses have the ability to re-invest the profits back into the business and generate high rates of return, allowing them to grow at an accelerated rate over time.
If Buffett and Danley continued to purchase pinball machines as the cash was coming in, they could have over 10 pinball machines by week 30 and over 100 by the end of the year! Keep in mind this is accomplished with a $50 investment, and no additional capital investments. Obviously in this case, two teenagers would likely not be able to keep up with this pace of scale, but it illustrates the power of strong cash flow and low capital expenses.
But eventually growth opportunities will run out. In this example, there are a limited amount of barber shops in town, or some competitor may join in on the action and cut the margins down. These are only a couple of several varying possibilities. Even strong businesses will eventually reach a point that it no longer makes sense to reinvest. This is a concept of understanding the runway of a business – or its ability to keep putting profits back into the business to generate larger returns.
Buffett and Danley ran into a myriad of their own issues and never managed to achieve 100+ pinball machines, but they were able to sell the business for $1,200, only a year after they started it. For young high school kids growing up in the 40’s, I would say this was an excellent result!
Conclusion
Buffett’s recount of his young entrepreneurial desire is a great testament to his business acumen. It’s a fun, short story, of an Oracle of investing.
The three core ideas of a successful business described herein, are ideas that Buffett continues to follow with his investments, even today; and are core ideas that you can apply in your entrepreneurial pursuits.
- A company’s ability to pay off its initial investments and continue to produce profits for the business will generate high rates of return.
- Low maintenance capital expenditures allow the company to continue operations and deliver profits by having lower capital needs.
- A great company has a long runway providing many opportunities to take the continuous profits and reinvest them back into the business, resulting in larger future profits.
I’m not quite sure he understood these concepts at the time, but it shows that his business ideas and aptitude from a young age were spot on. He claims that even though he doesn’t operate businesses directly anymore, the hands-on experience of running businesses in the past has served him well with his investment decisions.
Who is Warren Buffett?
Warren Buffett is a globally renowned investor, philanthropist, and business tycoon, often referred to as the “Oracle of Omaha”. As the chairman and CEO of Berkshire Hathaway, a multinational conglomerate holding company, Buffett has consistently been ranked among the world’s wealthiest individuals.
What was Warren Buffett’s pinball business as a kid?
As a teenager, Warren Buffett and a friend bought a used pinball machine for $25. They set it up in a local barber shop in Omaha, Nebraska. When it became popular and started making money, they reinvested the profits into more machines, eventually establishing a small business with several pinball machines across different locations.
Why did Warren Buffett choose a pinball business?
Buffett has always had an entrepreneurial mindset. The idea for a pinball business was driven by the opportunity to generate income with a low initial investment. His observation that people enjoyed playing pinball and his willingness to do the maintenance work on the machines also played a role in this early business venture.
What did Warren Buffett learn from his pinball business?
The pinball business taught Buffett valuable lessons about investment and entrepreneurship at a young age. It showed him the importance of reinvesting profits to grow a business, understanding customer behavior, and finding opportunities in unexpected places.
How did the pinball business end?
After running the pinball business successfully for a while, Buffett and his friend sold the business. This venture had been a profitable one, and it taught Buffett early lessons in profit-making and reinvestment, concepts that would later form the bedrock of his investment philosophy.
How has the pinball business influenced Warren Buffett’s later life and career?
The pinball business gave Buffett his first taste of success as a businessman. It taught him principles such as the importance of reinvestment, understanding the market, and identifying opportunities which he applied later in his career. His early entrepreneurial endeavors have helped shape his investment philosophy, favoring value investment and long-term growth.
Did Warren Buffett have any other early business ventures?
Yes, Buffett had numerous entrepreneurial pursuits as a child and teenager, including delivering newspapers, selling used golf balls and stamps, and detailing cars. Each of these experiences contributed to his business acumen and understanding of markets and consumer behavior.