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The most undervalued number on the balance sheet.

February 28, 2010 | About:
What do Psychemedics, Precision Castparts, Cal Maine and Apple have in common ?

For every dollar that was ever put to work in the business, they generate 20 cts of operating income today. For this group, retained earnings + paid in capital is less than 5x operating income. The outright owner of these companies would be smiling ear to ear.

Retained earnings are the sum of all historic earnings that were not paid out as dividends but instead reinvested in the core business or used to pay off debt. Retained earnings are also known as earned surplus, accumulated earnings or unappropriated profit.

Now if the intrinsic value of a business is the present value of all future dividends, then retained earnings are a good thing if they are allocated in a way that will produce a much greater dividend stream in future. If earnings are retained but not put to good use, it is fair to say the business, to date has been terrible from an owners perspective.

Using retained earnings as a starting point, businesses can be grouped into five categories.

I) Businesses with little or no retained earnings because they have not been very profitable over their lifetime. Photochannel serves as an example.

II) Businesses with significant retained earnings but a dodgy balance sheet. Ingersoll Rand in H1 2009 serves as an example. One way to do this is to retain earnings, overpay for a business and subsequently write down the goodwill. Another way is to report nonexistent earnings. This means retained earnings are high but there is no actual capital to deploy.

III) Businesses with high retained earnings and a high cash balance. George Risk and Solitron serve as examples. These are profitable businesses that for some reason do not pay a lot of dividend.

IV) Businesses with relatively low retained earnings in relation to their operating income but high debt. Aircastle serves as an example. These are companies that have sold debt to raise capital to grow the business. The assets come cheap to the stock investor. Beware of leverage though.

V) Businesses with hardly any retained earnings, a strong balance sheet and good earnings. From an owners perspective, these have been a good business to own. One way to do this is pay out a lot of dividends while maintaing a strong balance sheet (Psychemedics). Another way is to allocate the retained earnings wisely and grow.

Retained earnings are a simple, intuitive number linking the balance sheet and the earnings statement. If you are looking for evidence that a business is profitable and well managed, retained earnings (including paid in capital) are a good place to start.

Any and all questions welcome as usual; remember, do not overpay!

About the author:

Batbeer2
I define intrinsic value as the price I would gladly pay to own the business outright. With current management in place. For most stocks, that value is 0. As of September 2012, I'm the author of the monthly Buffett-Munger Best Bargains Newsletter. I can be reached at fvandenbroek AT gurufocus DOT com

Visit Batbeer2's Website


Rating: 4.4/5 (28 votes)

Comments

AlbertaSunwapta
AlbertaSunwapta - 4 years ago
Good discussion.

Investopedia's article: Evaluating Retained Earnings: What Gets Kept Counts is a nice complement to this discussion.

I don't know if it's a wholly undervalued measure though as other return measures capture facets of it. Additionally, I think it's worth noting that decades ago Warren Buffett highlighted the importance of the growth in aggregate book value in making assessments of the overall market and as far back as the early 50s Prof. Harkavey among others were noting the relationship between dividend policies, retained earnings and share prices.

Lastly, would Apple have fallen into the first grouping for much of its early life? How about other start ups?
batbeer2
Batbeer2 premium member - 4 years ago
Thanks for the link to an interesting article. There are two points in that article I disagree with.

Life can be hard for some companies - such as those in manufacturing - that have to spend a large chunk of profits on new plants and equipment just to maintain existing operations.

IMO retaining earnings just to maintain existing operations is a big mistake. Firstly, these are not true earnings. Reporting as earnings something you need to plow back into the business doesn't seem right. Secondly, maintaining the business, from an owners owners perspective, is not a goal in itself.

Another way to evaluate the effectiveness of management in its use of retained capital is to measure how much market value has been added by the company's retention of capital.

Taking that to its extreme means one should favour high priced securities over cheap ones.

Well worth reading none the less, thank you.

Your point about Apple probably holds true for precision castparts as well. For that matter, I think Photochannel has a decent chance of joining the group in the foreseeable future.

Yes, Buffett has written about these matters. It's after reading his letters that I started thinking about this.

Farmall
Farmall - 4 years ago
Very well thought out article Batbeer 2.
Dr. Paul Price
Dr. Paul Price premium member - 4 years ago


You previously called CalMaine 'one of the worst companies' to invest in.

What changed except the share price is now HIGHER?
Dr. Paul Price
Dr. Paul Price premium member - 4 years ago
Re: ‘Egg’-cellent Returns with Cal-Maine Foods

Posted by: batbeer2 (IP Logged) [Ignore this user]

Date: May 11, 2009 11:51AM

IMO CALM is one of the worst out there.

*******************************************************************************

CalMaine was $24.51 on May 11, 2009 when the write up was published and Batbeer2 called CALM one of the worst out there.

It closed at $34.46 (plus dividends) on Dec. 30, 2009 for a total return of about 42% for those 7.5 months.
Dr. Paul Price
Dr. Paul Price premium member - 4 years ago
Batbeer,

You also panned AAPL at $50 when i wrote it up in January of 2009.

. Batbeer2 says on Jan 16, 2009 at 10:45 AM:

Dear doctor,

IMO you are very focussed on price. You see, AAPL around $ 50 would by definition be a bad investment.
DaveinHackensack
DaveinHackensack - 4 years ago
Life can be hard for some companies - such as those in manufacturing - that have to spend a large chunk of profits on new plants and equipment just to maintain existing operations.

Isn't this true of railroads as well?

BTW, Batbeer, is that supposed to be a portrait of Spinoza?[/i]
fk
Fk - 4 years ago
I want to know how he gets his hair puffy like that. :)
batbeer2
Batbeer2 premium member - 4 years ago
@ Dave

Yes and yes. I'm not at liberty to post a picture of myself.

@ Fk

It's probably a wig. Spinoza featured on the Hfl 1000 bill back when there were dutch guilders. I believe he is one of Mungers favourite writers. He is relevant to Americans because the pursuit of happiness, as a right, is based on his writings.

@ Farmall

Thank you.

@ Stockdocx99

I don't think I said bad things about the company. Cal-Maine IMO is in a fiercely cyclical business and no where near the bottom of its cycle. I expected the cycle to be at it's bottom now; it has held up better than I expected altough there is now some evidence of margin compression.

As I track the company, I see evidence that it is well managed and actually has a good record of growth from cylcle to cycle. You will one day see my bull case for CALM on this forum.

As for Apple..... I like the company, I love the product but I don't like the stock. Oh and I would appreciate a link to the original thread if you quote me.

In general, when I use a ticker symbol I mean the stock. If I spell out the name It's the company.

Nice to see someone is tracking my picks and comments.
Dr. Paul Price
Dr. Paul Price premium member - 4 years ago
Batbeer,

Here's the Apple link:

http://www.gurufocus.com/news.php?id=45167

I didn't thinkt that your statement saying "IMO is one of the worst out there" was hard to interpret.

Nor did I think your view that "Apple around $50 would by definition be a bad investment" was equivical either.
jhodges72
Jhodges72 - 4 years ago
CALM has an inventory and receivables imbalance. The company in the last few quarters had an imbalance of its sales to inventory which resulted in its product outgrowing demand by a large percent. This event started to occur for the period ending Aug. 2008. Presently, as a result of this negative phenomenon, the inventory imbalance has continued to impact the business which has now left the company with an abnormal buildup in receivables. When product sales have slowed down and inventories have built up, the end result is that receivables build up and products that were shipped aren't being payed for. 4 out of 5 times this results in loss of earnings and market price fluctuation. It is my belief that the increase of receivables has given CALM a false sense of a book value increase when in fact, the reason of the increase has more to do with mis-management of the company's inventory. Therefore, the $32.xx share price you see currently, in my opinion, will diminish in the near future (6 months).
batbeer2
Batbeer2 premium member - 4 years ago
When product sales have slowed down and inventories have built up, the end result is that receivables build up and products that were shipped aren't being payed for.

In the case of Cal-maine, inventories have a pretty steep depreciation schedule.
jhodges72
Jhodges72 - 4 years ago
They'll need it at the rate their Inventories & Receivables are building up at the same time as their Sales declining.
batbeer2
Batbeer2 premium member - 4 years ago
Jhodges72

To be clear, I'm very bearish on the stock near term. I stand by my fair value estimate of a while ago and expect to be able to buy at a discount to that in the foreseeable future.

I put in my vote when CALM was trading at low single digit p/e and double digit dividend yield.

Very slowly, the cycle is turning. One reason is because of a weak dollar. Farmers bred chickens for meat (exports) and not for eggs. Now that the dollar has strengthened, I expect a lot of farmers to switch to eggs.
Dr. Paul Price
Dr. Paul Price premium member - 4 years ago


Batbeer,

You were very harsh in your criticism of CALM and AAPL when I wrote them up.

Now that both of them are much higher can't you be a man and admit you were totally wrong in each case?
DaveinHackensack
DaveinHackensack - 4 years ago
Why all the one-star votes for the Doc here? He doesn't always have the best bedside manner here, but he does seem to have a point WRT these two stocks and Batbeer/Spinoza's previous comments about them.

Batbeer, Remember that Spinoza entitled one of the books in his Ethics, "Of Human Bondage". He was talking about emotions, as you know. Pride is an emotion. It can sometimes prevent us from acknowledging mistakes. I say this as someone who respects your thinking and values reading your comments. Perhaps your earlier comments on these stocks weren't mistakes, in your view. If so, why not explain why?
AlbertaSunwapta
AlbertaSunwapta - 4 years ago


Another way to evaluate the effectiveness of management in its use of retained capital is to measure how much market value has been added by the company's retention of capital. ...

Yes, however as with measures like, EVA (MVA), it doesn't lend itself to the discovery of value due to significant unrecognized "effectiveness of management". As with Apple, I'd say management effectiveness is fully recognized and valued into the share prices.
batbeer2
Batbeer2 premium member - 4 years ago
Now that can't you be a man and admit you were totally wrong in each case?

I can but I won't. I'll admit I was mistaken with Belzberg: http://www.gurufocus.com/forum/read.php?2,37844,43101#msg-43101

I'll admit I was early with Cal-maine: http://www.gurufocus.com/forum/read.php?2,31075,31103#msg-31103

@ Dave

Can't help you there; I have not given Stockdocx99 one star this year. I do however feel stockdocx99 is dragging this thread off-topic.

@AlbertSunwapta

Good point.


Dr. Paul Price
Dr. Paul Price premium member - 4 years ago


Batbeer,

If CALM and AAPl look good now [due to high retained earnings] as your article says then how could they have looked BAD just months ago at MUCH LOWER PRICES?
jhodges72
Jhodges72 - 4 years ago
beerbat2,

"The Intelligent Investor" (Benjamin Graham), Page 81:

"Companies that are inherently speculative because of widely varying earnings tend to sell both at a relatively high price and at a relatively low multiplier in their good years, and conversely at low prices and high multipliers in their bad years."

I wouldn't be excited about the P/E ratio unless you are using a cyclically adjusted one.

Stockdocx99,

Apperantly you're under the assumption that price equals value. You either had a bad teacher, you didn't listen, or you don't understand.

batbeer2
Batbeer2 premium member - 4 years ago
If CALM and AAPl look good now [due to high retained earnings] as your article says....

AHA ! Now I see where the confusion arises.

1) If after reading the article you conclude I'm bearish on Photochannel or bullish on Cal-Maine and Apple, you are reading thngs I did not write. In fact, I may well have been bullish on Ingersoll-Rand in H1 of 2009. Interestingly you do not point this out as being inconsistent.

2) If you conclude, after reading the article, that any company with high retained earnings looks good, then you are not reading things I did write.

The topic is retained earnings. I shall respond to posts on this topic. You wish to discuss my performance as a stock picker, start a new thread.
batbeer2
Batbeer2 premium member - 4 years ago
Now that can't you be a man and admit you were totally wrong in each case?

One last thing.... I congratulate you on those picks. Whether or not I was mistaken is something we may not agree on in the foreseeable future but these writeups were undeniably succesfull and I was indeed harsh.

There are many ways to skin a cat.

augustabound
Augustabound - 4 years ago
You need to let it go doc.

Don't you have a Barron's article to cut and paste? Then reply to your own post with another Barron's cut and paste....

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