Retained earnings

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 Value Line, 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 = 19.35
          8.01

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.