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Retained earnings

January 21st, 2013

Splitting company profits

When a corporation makes a profit, it can spend that profit in two ways:

a) return the profits to stockholders by way of dividends, share buy-backs or bonus issues;

b) use the money to increase the profitability of the company

For example, a company makes a profit of $100. It can pay this entire amount to stockholders who can then use that money as they think fit – spend on consumer items, make further investments, whatever. Or the company can use all that profit to invest in the business with a view to increasing profits in future years. Or the company can do a bit of both.

Wise use of retained earnings interests Warren Buffett

To Warren Buffett, the ability to use retained earnings wisely is a sign of good company management. If the company management cannot do any better with earnings than he can, then he is better off if the company pays him the full amount in dividends.

Warren Buffett on retained earnings

In 1984, Warren Buffett made these comments:

Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.

Warren Buffett’s test for retained earnings

The test for Warren Buffett is whether company management can transform each dollar of earnings retained into no less than a dollar of market value. The period he implies that he uses is 5 years (on a rolling basis).

Using the retained earnings profitably is not enough for Warren Buffett. The retained earnings must increase earnings substantially. After all, just leaving the earnings in a savings account will increase earnings without any effort.

Warren Buffett has suggested to investors that they need to predict, after reasoned analysis, what rate of return a company will average over the near future. The rest is simple.

You should wish your earnings to be re-invested [by the company] if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of re-investment.

An alternate test for Warren Buffett?

Mary Buffett and David Clark see Warren Buffett’s test from an additional perspective. They take the total value of the profits retained and use them to calculate the rate at which profits have increased by the use of that money.

Take for example, Canon Inc. Using figures available from ADVFN we can calculate that, in the period from 1993 to 2002, Alcoa earned a total of $9.56 per share. It paid a total of $ 1.55 to shareholders by way of dividends. This means it retained profits over that period amounting to $8.01.

In that period, earnings per share grew from .24 to 1.79. That is, all the profits retained by the company ($8.01 per share) resulted in the earnings per share rising 1.55 (1.79-.24). To show the return percentage, the calculation is

1.55 x 100/8.01= 19.35

A return of 19.35% would be acceptable to most investors but, in the end, shareholders would have to consider whether, had they received all the profits by way of dividends, they could have put the money to better use.

It is this ability to use retained earnings of a company to increase earnings at a higher than market rate that attracts successful investors like Warren Buffett.

Posted by Julian Livy on January 21st, 2013 | Posted in How Buffett invests |