Warren Buffett's Test for Retained Earnings

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.

  

Warren Buffett on Retained Earnings: For every dollar retained, at least one dollar of market value will be created for owners over 5 years.

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.’

Retained Earnings are central to the process of investment growth

A company adds up its income, subtracts its expenses, and pays any dividends due; what is left becomes retained earnings.  These are undistributed profits.

Undistributed profits or retained earnings are central to the process of investment growth.

The net worth of the company builds up through the reinvestment of undistributed earnings.

Corporate raiders in particular love to find a company with a lot of cash reserves accumulated from retained earnings.

There is a legitimate dispute over how much retained earnings are adequate, and at what level a company should let loose of some cash and distribute it to shareholders.

Overall, retained earnings like the payment of dividends, deliver a powerful message:  the company generates more cash than it needs for the operation of the business.

That's exactly what a good investment should do.  

These earnings, over and above total expenses and taxes, drive the share price higher.

Common stocks have one important investment characteristic and one important speculative characteristic.  

• Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings.
• The speculative feature is no mystery.  It is the tendency toward excessive and irrational price fluctuations as investors (in Graham's words) "give way to hope, fear, and greed."